If you are looking to reach financial goals that can set you up in the next stages of your life, creating a savings strategy is a great way to lay a foundation for your current and future goals. That includes saving for your child’s future and future education. Two popular savings options for children are 529s and traditional savings accounts, but is one better than the other? If you’re considering a 529 plan vs. savings account for your child, it’s important to understand how they compare and which option can help you reach your goals sooner.
In this article, we’ll explore the fundamental differences between a 529 plan and a traditional savings account. How do they operate and what benefits or limitations can you expect from either option? Understanding these key differences can help you choose the right savings strategy for your particular goals. The details that follow will help you in choosing between a 529 plan vs. a savings account.
What Is a Savings Account?
Chances are, you are familiar with what traditional savings accounts are and how they work. In short, this simple savings tool is a secure place to store your money. Anyone can open a savings account, adult or child—or an adult for the benefit of a child. Typically, you can access the funds as needed, and the account comes with the benefit of growing a little extra through earned interest.
What Is a 529 Plan?
A 529 plan is a type of tax-advantaged investment account designed specifically for educational expenses. Similar to an IRA, contributions are invested according to risk tolerance and grow according to the current market.
Higher education is costly, and parents preparing their children for postsecondary education can benefit from creating a savings plan to cover tuition and other associated fees, such as books, supplies, or equipment necessary for courses of instruction.
In the past, 529 plans were restricted to postsecondary education—that is, formal education after high school, such as college, university, vocational school, and life school programs. Now, 529 plans have a wider scope, with funds being permitted to cover costs of K-12 education, apprenticeship programs, student loan repayment, and Roth IRA contributions.
How Do 529 Plans Work?
Anyone can open a 529 account, but they are more typically opened by a benefactor, such as a parent or grandparent, on behalf of their child or grandchild. If the account is opened by a benefactor, it will remain under the benefactor’s control.
A 529 account’s sole purpose is to cover educational costs. If the money is used for qualified educational expenses, withdrawals are not subject to state or federal tax. Qualified expenses are set and detailed by the IRS. Keep in mind that tax benefits vary across states, and therefore, the rules and fees associated with 529 plans can be different from state to state. It’s important to check the specific tax benefits of your state so you understand what you may be entitled to.
There are two different types of 529 plans: educational savings plans and prepaid tuition plans. Educational savings plans offer tax-advantaged accounts to cover educational expenses, while prepaid tuition plans lock in current tuition rates (which are typically lower than future rates) with selected colleges and universities for future attendance.
529 Plan vs. Savings Account: How Do They Compare?
The primary benefit of 529 plans is their tax-deferred growth, with tax-free withdrawals and higher growth potential. However, these advantages are only for eligible education expenses. If you use your funds for anything other than qualifying education expenses, you will be required to pay a penalty and income tax (state and federal) on any earnings. This could make it difficult to access the funds in the account if your child ultimately opts not to pursue higher education.
Conversely, savings accounts do not restrict how you spend your money and, therefore, can provide more flexibility. If your child chooses not to attend college, no problem. Though interest is subject to income tax, your funds are available to you as needed. If your financial or life goals change, you do not have to update your savings plan to account for these changes, nor will you face penalties for spending your savings on non-educational expenses.
Savings accounts typically do not have contribution limits, while 529 plans do, and you may trigger a gift tax if you go over. However, the annual 529 contribution limits per beneficiary are quite high.
As investment vehicles, 529 accounts carry more risk than traditional savings accounts. Markets can drop, causing your 529 account to lose value. Once money is deposited in a savings account, on the other hand, it can only grow based on the interest rate. (The exception might be paying for potential account fees.) No matter how low the market goes, your initial investment is safe. Choose a financial institution insured by the FDIC or NCUA, and your account is secure up to $250,000 even if the institution fails.
Which Savings Plan Should You Choose?
Which account should you choose to financially plan for your child’s future? This will ultimately depend on your specific objectives and circumstances. Do you want the funds to only be available for educational expenses? How much do you plan to contribute to the account? What are your tax needs?
Before deciding, let’s look at a simple breakdown and weigh the benefits of each.
Purpose
A 529 plan is an investment account specifically for educational expenses, while a savings account can be used for any purpose.
Restrictions
A 529 plan can only be used without penalty for qualifying educational expenses, while savings accounts are more flexible and can be used as desired (restrictions may depend on bank or credit union policies).
Investments and Returns
A 529 plan is invested in assets such as stocks and bonds; they are part of a higher-risk investment strategy but may yield higher returns. Savings accounts earn interest only and, therefore, are lower-risk.
Tax Advantages
A 529 plan offers tax-free growth and withdrawals for qualifying education expenses. There may also be state tax deductions or credits depending on the state. Interest earned annually on savings accounts is classified as taxable income.
The Bottom Line
Both a 529 plan and a traditional savings account can be viable options to save money for your child’s future. You can implement one or both as a part of your financial strategy. Benefit from the tax advantages of a 529 plan (tax-deferred growth, tax-free withdrawals, and tax-deductible contributions) and the flexibility and freedom of a savings account.
If you have questions about your savings journey, schedule an appointment with your local credit union to discuss your savings options.
Your future is yours; now is the time to start investing in it!
