529 Plans 101
Congratulations on opening your 529 plan! Now, it’s time to start building your portfolio. Here, I provide a simple overview of the range of investment options available within the 529 plan, so you can make an informed decision.
A 529 plan works much like other types of investment accounts, though investment options differ between state plans. Generally, plans offer age-based and target enrollment date portfolio options, and static portfolio options.
Age-based and target enrollment date portfolios
An age-based/enrollment date-based portfolio has a target-date fund that reallocates investments based on a child’s age. In other words, Indeed, the portfolio is more aggressive in the beginning years of your fund, with higher allocation to risky investments with high return potentials, like stocks. As your child’s college enrollment date/age nears, the portfolio becomes more conservative, pivoting to low-risk investment options like money market funds. This ensures that your funds will be available by your target-date.
Static Portfolios
Static portfolios offer a fixed-allocation strategy. This means that your portfolio’s asset allocation will not change, unless you reallocate them manually. Your investments stay within a portfolio until you decide to either close the account or opt to switch portfolios, a choice permitted twice annually.
Selecting a Portfolio Type
The key difference between the two portfolio options is that asset allocation is automatically adjusted over time in age-based portfolios, while remaining stagnant within a static portfolio.
If you don’t want to worry about monitoring your investments, you may want to opt for an age-based portfolio. Remember that risk levels of age-based portfolios can vary significantly between state plans, so carefully consider your risk tolerance, timeline, and objectives when choosing your plan.
If you are a seasoned investor with specific investment strategies or seeking to mirror another investment, a static portfolio may be a better option for you.
The Aftermath
After you select your investment strategy, professional investment managers or firms selected by the plan administrator will make investment decisions on your behalf. Plan administrators have investment oversight committees or boards responsible for monitoring the performance of the investment options and selecting or replacing investment managers as needed. You will receive regular statements and updates on your investments’ performance within the 529 plan.
But there is one caveat. Let’s talk about what to do if your 529 plan beneficiary decides not to pursue a college education.
While there are numerous advantages associated with 529 accounts, one drawback has been the penalty imposed on families when withdrawing unused funds from the account if their child decides against pursuing higher education or completes their education without utilizing all the funds. This penalty consists of a 10% federal penalty and potential taxation of the withdrawal.
Let’s consider a few options before withdrawing the funds, and incurring a penalty:
Keep the Funds in the Account: You can choose to leave the funds in the 529 plan account. While you won’t incur penalties for leaving the funds untouched, any non-qualified withdrawals in the future may be subject to income tax and a 10% penalty on the earnings portion.
Save for Graduate School or Continuing Education: If you plan to pursue graduate school or further education in the future, you can keep the funds in the 529 plan account and use them to cover qualified expenses for advanced education. This allows you to continue benefiting from the tax-advantaged growth of the funds.
Change the Beneficiary: If you have other family members who can use the funds for their qualified education expenses, you can change the beneficiary on the 529 plan to another eligible family member, such as a sibling or cousin. This allows you to continue using the funds for educational purposes without incurring taxes or penalties.
Rollover to Roth IRA: In December 2022, a significant legislation was passed by Congress, introducing a new provision that allows tax- and penalty-free rollovers from 529 plans to Roth IRA accounts starting in 2024. This development provides families with increased flexibility in their financial planning for future educational expenses.
If you receive a scholarship and no longer need the funds from your 529 plan?
You can withdraw the funds from your 529 plan penalty-free up to the amount of the scholarship. However, you will still need to pay income tax on the earnings portion of the withdrawal. This means you’ll avoid the 10% penalty typically applied to non-qualified distributions, but you’ll owe taxes on the earnings portion of the withdrawal.
Ultimately, the best course of action will depend on your individual circumstances and financial goals. It’s important to consider the potential tax implications and consult with a financial advisor or tax professional to make an informed decision about how to handle the funds in your 529 plan after receiving a scholarship.
Once you’ve selected an investment strategy that meets your needs, you can rest assured that your funds will grow until your child’s long-awaited college move-in day. And, if the funds remain unused, the rules can vary, so it’s a good idea to check with your specific 529 plan provider for all the details on beneficiary changes and non-qualified withdrawals.
Your financial journey is unique, so make choices that work for you. Continue to learn more from our 529 series.