640px-Shelter

Like this, but for money.

I don’t know if its clear that I like tax shelters.  They shelter your money from tax.  That saves you money.  Yay.

A 529 plan is a type of tax shelter that helps you save for educational expenses.  So if you have kids, or you think that you’re ever going to take a cooking class or something, listen up.

The Benefits

No state income tax on contributions or qualified withdrawals.  In Colorado the state income tax is 4.63%.  Contributions to the Colorado 529 plan are deductible from your Colorado state income taxes. Many states offer similar plans.  No taxes going in, no taxes going out.  Colorado will also match your contributions up to $400 annually for five years. You do have to meet income limitations (~$60,000 for a couple with a kid).  If you qualify for something like this, just do it.  Seriously.

Earnings on money invested in a 529 plan are not subject to federal tax on qualified withdrawals, kind of like a Roth IRA.  (I don’t think I need to explain how awesome this is. It’s awesome.) Additionally, even if withdrawals are ultimately used for tuition you don’t have to pay taxes until you actually withdraw the money from the account, this allows money to compound without substantial tax consequences.

The really crazy thing about these plans is that the limit for the amount you can contribute is really huge.  Somewhere between $230,000 and $310,000 huge.  This is a limit that is per beneficiary.  So the kids get a 529 plan, the spouse gets a 529 plan, you get a 529 plan.  Go completely Oprah on this.  It’s absolutely insane as a tax shelter.  There’s been some talk about reining these in, so keep that in mind. They’re mostly owned by older, upper-middle class folk.  This helps a little bit because older, upper-middle class folk vote in droves so its very hard to take something away from them. *Cough* mortgage interest deduction *cough*.

The Catch

The money has to be used for qualified education expenses.  Obviously this includes tuition and fees at qualified institutions (places, like universities, that could participate in a financial aid program from the Department of Education.) This also includes books, tutoring, room and board, uniforms, and transportation. If you withdraw for another reason then you have to pay federal taxes on earnings, plus an additional 10% penalty.  The notes about just giving up and paying the penalty when we talked about the Roth IRA, totally apply here too.  A 10% penalty is just not that much when you consider that you get to sit on perhaps a substantial amount of tax deferred compounding.   Of course if the 529 plan is in your kids name, it is still their money.

Your investment options are also pretty limited.  This isn’t like an IRA where you can buy a bunch of call options if you want to (don’t do that).  The strategy here is just to select a Vanguard option, put everything in a couple index funds and never look at it again.  Market timing with indicies is dumb, don’t do it.

The Options

Every state has their own 529 plan.  You can join other state’s 529 plans.  This makes it worth it to poke around for the best option for you.  In my case the tax deductibility for Colorado’s plan made a big difference.  If you live in a state that doesn’t have an income tax then you might profit from looking around a little bit. I’ve seen Nevada’s 529 plan recommended quite often.  The big benefit here is a huge ($370,000) contribution limit.  They don’t have a match for non-residents. Unfortunately, it seems like most states aren’t keen to hand out free money to people that don’t live there. Imagine my surprise.

So should I…

Do it.  After you fund your other tax sheltered stuff, that is.  Obviously if you haven’t already contributed to your IRA, 401k, and HSA, go ahead and contribute to those. The timing of 529 funding is really flexible, but with all investments earlier is still better.  There’s some thought going around that you only get so many heartbeats in a lifetime, the same is true for tax-advantage space. It’s only $5,500 per year in your IRA, $18,000 per year in your 401k, and $3,350 in your HSA.  That’s almost $27,000 per year, adding another $370,000 over a lifetime (+370K per child, woo) makes a big difference.  Millionaires have taxable brokerage accounts.  Thousandaire’s money lives in shelters.