How to Avoid Student Loan Debt with 529 Plans?

We are all familiar with the student loan issue in America.
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In fact, it was this problem that sparked the interest of our founder, Joyce, in becoming an expert in the topic of personal finances.

Despite having an economics degree and working as a sales trader at Goldman Sachs, Joyce found herself struggling with overwhelming student loan debt. This original experience inspired her to build Investrio, with a mission to provide a personalized financial experience for young professionals.

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We have a special Q&A below with Shankar Nayaranan, a Ph.D. in Financial Economics, a parent of twins, and a dear friend of Investrio.

Parents, you can start planning for your young children today and help them avoid student loan debt down the road. The tool you are looking for is called a 529 plan. (This article was originally posted on Medium).
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College in most parts of the world is becoming a challenge. Being a finance professional, I am often asked this question: how to support child education in collegee?

In this article, I mainly focus on undergraduate or bachelor’s education in the United States. As the saying goes, the sooner one starts saving, the better it is for the future. While there are several channels for getting aid or university scholarships, my article focuses on the savings in the popular 529 plan.

The article is timely as beginning in 2024, new rules are being suggested for the unused part of the 529 plans. In this article, the “beneficiary” is the child; typically, the individuals are the parents contributing to the 529 plan.

So, how can parent help their children avoid student debt?

Q: What is a 529 plan?

A: A 529 is a tax-advantaged savings plan designed to help families save for future education expenses. For most parents saving for the tuition of their beneficiaries, children or grandchildren in most cases. College 529 provides a tax-deferred way of investing in the equity markets.
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Q: What expenses can a 529 plan cover?

A: The 529 can cover the beneficiary’s qualified higher education expenses, including tuition, fees, room and board, books, and supplies. There is a limit that can be used for K-12 tuition also.
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Q: How does a 529 plan work?

Shankar: Contributors invest money in the 529 plan, and the earnings grow tax-free. When the funds are withdrawn to pay for qualified education expenses, the withdrawals are also tax-free.
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Q: What are the types of 529 plans?

A: There are two main types of 529 plans: prepaid tuition plans and education savings plans. Prepaid tuition plans allow you to prepay tuition at today’s rates. While education savings plans let you contribute to an investment account to cover future education expenses. The disadvantage of prepaid plans is that the child might choose another college outside the plan.
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Q: Can I use a 529 plan for any college?

A: Generally, yes.
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Q: Will the 529 plan adversely impact the chances of getting tuition aid?

A: No, the 529 plan is considered as the parent’s asset used for the kid’s tuition, unlike Custodial accounts (UGMA or UTMA), which are considered to belong to the beneficiary upon reaching a legal age, which is typically 18 or 21, depending on the state.
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Q: What are the other differences between the Custodial and 529?

A: There are several, and there are benefits to using both. Custodial accounts are not tax-deferred but taxed upon withdrawal by the beneficiary when they reach the legal age.
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Q: What happens if the beneficiary doesn’t use all the funds in the 529 plan?

A: Suppose the beneficiary (the student) uses only some funds. In that case, the account owner can change the beneficiary to another qualifying family member (a sibling) without incurring taxes or penalties. Also, the parent can convert up to $35,000 lifetime dollars (as of 2024) to the kid’s Roth IRA account — more on this in the next question.
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Q: Can I use a 529 plan to pay for student loans?

A: No, using a 529 plan to pay off existing student loans is not a qualified expense, and any withdrawal for this purpose may be subject to taxes and penalties.
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Q: Are there contribution limits for 529 plans? Can I have multiple 529 plans for one beneficiary?

A: Yes, each state has its contribution limits, and they vary. The limits are often high, and they may be based on the expected cost of education. Yes, you can have multiple 529 plans for the same beneficiary. However, the total contributions from all plans for the same beneficiary can be the state’s maximum limit.
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Q: What if the beneficiary receives a scholarship or goes to a military school?

A: If the beneficiary receives a scholarship or goes into the military, you can withdraw funds equal to the scholarship amount without incurring the usual 10% penalty on non-qualified withdrawals. However, you will still need to pay taxes on the earnings portion of the withdrawal. It will be taxed at the owner’s (parent’s) tax bracket.
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Q: Can I transfer all the unused money to my kid’s Roth IRA?

A: Note that while an unused 529 plan can be converted into the beneficiary’s Roth IRA, one can only contribute to the extent of the beneficiary’s earnings and can be within the annual limit of $6,500 (as of now) per year. If, in a given year, the beneficiary makes only $3,000 as qualified earnings, only $3,000 can be moved from the beneficiary’s 529 plan to their Roth IRA. Furthermore, there are classifications of what constitutes eligible earnings. If the beneficiary worked at a restaurant, the salary qualifies for the Roth IRA contribution, not the tips.
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Q: What are the other alternatives to parent-owned plans?

A: One can save in a typical savings account that yields a nominal 3–4% today. One can also open a savings bond account with Treasurydirect.gov. For example, the i-bonds (inflation bonds) have a yearly limit of $10,000 per individual, but the funds used towards tuition expenses are tax-free. However, it will yield a fixed floating rate tied to the inflation. (This resets every 6 months)

Another is the traditional way of investing in the equity markets and taking a portion when needed. If disciplined, the individual can contribute a monthly dollar towards Treasury Bonds, SPY (S&P 500 ETF), and QQQ (Nasdaq ETF) and sell the necessary funds for tuition payment. There will be long-term capital gains tax levied upon withdrawal, unlike the 529 plan, but it has more flexibility. Not financial advice just some ideas to structure your upcoming goals.

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Thank you Shankar for sharing your thoughts with us!

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About Shankar:

Shankar has over 15 years of industry experience, including several years as a mid-to-high frequency researcher and statistical-arbitrage portfolio manager. He currently works at Quantitative Brokers and has a Bachelor's in Chemical Engineering from the Indian Institute of Technology, a Master's in Financial Engineering from U.C. Berkeley, and a Ph.D. in Financial Economics from The City University of New York. His doctoral dissertation was on price discovery and market microstructure. ‍

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Disclaimer: The article is not an investment advice of any kind. Please do your due diligence and consult a CPA to know more about the exact implications and details of the taxes. All of these views are expressed as our own opinions and do not express the views or opinions of any employer.