Saving for a child’s college education is a significant financial goal for many families, with 529 plans being one popular savings plan. But does a 529 plan earn interest, and how does it generate earnings for higher education?
In this article, we will provide the short answer, the long answer, and some helpful tips for maximizing the benefits of a 529 plan for education savings.
Do 529 Plans Earn Interest?
Interest vs. Investment Returns
A common question parents have is whether 529 plans earn interest. The short answer is that no, 529 plans do not earn interest in the same way a traditional savings account does.
The longer answer is that they generate returns, so your invested money is growing. The difference is that your earnings (the amount that your contribution grows over time) are based on the investments within the plan. These investment returns can come from interest on bonds, stock dividends, and capital gains from appreciating your investment options.
How Investment Choices Affect Earnings
The account owner, usually a parent, grandparent, or family member, can invest the funds in a 529 plan in various ways. Your choices here will determine how much your 529 account earns. Most 529 plans offer a variety of investment options. These include age-based investment accounts, individual mutual funds, and exchange-traded funds (ETFs).
Like other investments, there is always a balance between risk and reward. For instance, stock-heavy portfolios may offer higher returns but come with greater risk because stock prices tend to be more volatile than other investment types. Bond-focused portfolios, on the other hand, may provide more stability but with lower returns.
Comparison with Other Savings Options
Compared to other savings options, 529 plans have the potential for higher returns due to their investment in the stock market. Traditional savings accounts or certificates of deposit (CDs) typically offer lower interest rates (around 0.6% annually).
In 2024, most banks offer around 5% for a high-yield savings account (HYSA). It’s worth noting that HYSA rates are currently at record highs. Like most interest rates, these are tied to the federal funds rate set by the Federal Reserve, which can change regularly.
On the other hand, 529 plans have the potential for greater earnings on investments. For example, the 1-Year Performance for The Vanguard 529 College Savings Plan investment options currently ranges from 4.6% to 17.35%. They also offer tax advantages and investment flexibility that savings accounts do not, making them a more attractive option for college savings.
How Earnings are Generated in a 529 Plan
Role of Mutual Funds and ETFs
Common investments for 529 plans include mutual funds and ETFs. Mutual funds pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities with the funding you provide.
ETFs are similar to mutual funds but they trade like individual stocks on an exchange. You can purchase stock in an ETF and trade it like an individual stock. As these investments grow, the value of the 529 plan increases.
Fund managers, who work for institutions like Vanguard, have decision making rights about how the money gets invested. These are experts who also invest funds for retirement accounts and other investment vehicles.
Benefits of Investing in a 529 Plan
The primary benefit of enrolling in a 529 plan is the potential for tax-free growth. Earnings in a 529 plan are not subject to federal income taxes. In many cases, withdrawals are exempt from state taxes as long as they are used for qualified education expenses.
Avoiding taxes significantly boosts overall returns, whereas most traditional investments that earn returns are subject to capital gains taxes.
Potential for Growth Over Time
It is probably apocryphal, but Albert Einstein is said to have observed that compound interest is the most powerful force in the universe. No matter who coined the phrase, every financial advisor knows that compound interest is the friend of anyone who hopes to save for education after high school.
Saving for college early in a 529 plan gives it more time to grow. Compounding means that small, regular contributions can grow over time to become a substantial sum when your child is ready to go to college.
Consider this: you want to put away $200 a month for the next 15 years to save for your 3-year-old’s college education. Let’s look at some of the ways you could use that money.
If you put the money under the mattress on her high school graduation day, you will have $36,000 saved. That’s a nice chunk of change, but it could be better.
What if you put it into a savings account? Between the start of the Great Recession and the COVID-19 pandemic, interest rates were at historic lows. If you put that money into a simple savings account, you would have less than $39,000. That is some return on your money, but not much.
If you invest it fairly conservatively with a 6% annual return, you will have $57,840 saved the day the first tuition bill comes due. Not too bad. And Vanguard’s top-performing 529 plan has a 16.59% average annual return over the last ten years! If you were invested in this fund over the last 15 years with that annual return, you would have $143,028 today. That is a lot of money that can be used for tuition, books, or other qualified expenses.
Factors Influencing Earnings in a 529 Plan
Economic Conditions
Many factors go into determining the performance of a 529 plan. Inflation has been a hot topic for the last several years, but interest rates, government spending, and economic growth also play a role. All of them will affect the return of stocks and bonds in your 529 plan.
While individual investors cannot control these, understanding them can help you make more informed investment decisions. The best course of action is to start early so that you have time to compensate for any dips in the economy. Of course, ask your financial advisor if you have any specific questions or want to align your investment strategy with your risk tolerance.
Fund Management and Performance
Mutual funds and ETFs are professionally managed. When managers perform well, meaning they make good decisions about asset allocation and investment selection, the value of their funds goes up. Your balance will increase if your 529 plan is invested in these funds. Because this is a critical element of your 529’s performance, it is important to research and choose plans with a strong track record and reputable fund managers.
Risk Tolerance and Portfolio Allocation
Investments that have the potential for higher returns usually also have higher risks. Your risk tolerance will determine the way you allocate your portfolio. More aggressive portfolios—those with a higher proportion of stocks—can offer higher returns. They also have greater volatility, so the balance will rise and fall with the market and other economic conditions.
On the other hand, a portfolio heavily tilted towards bonds or money market funds will be steadier, but the trade-off is lower growth potential.
Strategies to Maximize Returns in a 529 Plan
Diversifying Investments
Investing 101 teaches you that you shouldn’t put all your eggs into one basket. Like any other investment vehicle, you should diversify your 529 savings plan to maximize returns and minimize risk when saving for college. By holding stocks, bonds, international funds, and more, you can reduce the impact if any sector performs poorly.
When choosing investments in your 529 plan, you can invest in funds comprised of most of these vehicles to keep your 529 diversified. Most 529 plans offer options that automatically reduce the overall risk by changing the allocation as the child approaches college.
Imagine Emma’s face when she learned that her college was paid for, thanks to the 529 plan her parents started when she was a baby. They had saved diligently, and now Emma could pursue her dreams without financial worries.
Periodic Review and Adjustments
Regularly reviewing and adjusting your investment strategy is essential for keeping your 529 plan on track. A big change in your family situation, an economic shift, or a major move in the market could necessitate a change in your portfolio. Reviewing your asset allocation periodically will keep your investments in line with your financial goals and risk tolerance.
Contributions and Timing
One of the easiest ways to grow a 529 plan over time is to make consistent contributions by setting up monthly automatic transfers. And, if you make larger contributions during market downturns, each dollar buys more stock. Then, when the market goes back up, your portfolio will rise even further.
Starting to invest earlier also gives your contributions more time to grow with compounding returns. So, the earlier you start saving (even a smaller amount), the more you’ll have saved by the time your child is ready for college.
For example, if your goal is to save $50,000 by the time your child gets to college, you would need to save $123 if you start the month they are born. If you wait until they are 10, you must put away $385 each month to accumulate the same $50,000 by their 18th birthday. If you start earlier, you don’t need to save as much each month.
Comparing 529 Plan Earnings with Other Savings Vehicles
529 Plans vs. Savings Accounts
Savings accounts offer safety and liquidity but typically provide lower interest rates compared to the potential returns of a 529 plan. While savings accounts are suitable for short-term goals, 529 plans are better suited for long-term college savings due to their investment growth potential and tax advantages.
529 Plans vs. Roth IRAs
Roth IRAs are another option for college savings. Like 529 plans, they offer income tax-free withdrawals for qualified education expenses. However, Roth IRAs have annual contribution limits of $7,000 in 2024 and are primarily designed for retirement savings, not college expenses. A 529 provides increased flexibility, higher contribution limits, and was specifically designed for education expenses.
529 Plans vs. Brokerage Accounts
Brokerage accounts offer the flexibility to invest in a wide range of assets, but they lack the income tax advantages of a 529 plan. Earnings in a brokerage account are subject to capital gains taxes (as much as 20%), whereas 529 plan earnings grow tax-free if they are later used for qualified education expenses. For college savings, 529 plans are generally the more efficient option.
Common Misconceptions About 529 Plan Earnings
Clarifying Interest Myths
A common misconception is that 529 plans earn interest like a savings account. The reality is that returns from 529 plans come from many sources. These include interest on bonds, dividends from stocks, and capital gains. With a better understanding of where the money comes from, you can set realistic expectations and make better decisions about your education savings.
Understanding Compounded Earnings
The power of compounded earnings is a significant advantage of 529 college savings plans. The returns on your investment get automatically reinvested, so they also start earning returns.
By reinvesting dividends and capital gains, the account can grow exponentially. With consistent contributions and a long investment horizon until higher education, this can be a game changer.
Making the Most of Your 529 Plan
While 529 plans do not earn interest like the traditional savings accounts many are already familiar with, they offer significant growth potential. By understanding how these plans generate earnings, and the factors that influence their performance, you can maximize your college savings.
By implementing smart investment strategies that earn returns, regularly reviewing your plan, and taking advantage of the tax benefits, you can effectively save for your child’s education costs.
