Saving Money for College- 529 Plans Explained
By: Haley Callicott, Contributor
In a time when college tuition costs nearly as much or more than a home, it is more important than ever for parents to start thinking about an investment plan for your child’s future education. However, there are many misconceptions and financial jargon that surround the understanding of a 529 plan because of the different types and offerings of plans that vary by state. Luckily, we’ve broken down the terminology and types of 529 plans to make it easier for you to start planning for your child’s future.
What is a 529 Plan?
A 529 plan is a higher education savings plan that is exempt from taxes and specifically designed to help finance a child’s college or university expenses. The idea behind the plan is to encourage account holders to set up a plan and start saving money for the beneficiary’s future. 529 are especially ideal in today’s economy because the funds in the account are tax-exempt, which allows the funds to grow over time and withdrawn once the beneficiary reaches college. However, all states enforce a contribution limit that is typically between $300,000-$500,000.
Anyone can open up a 529 plan and they are either operated by a state or educational institute and can be expensed through a savings plan or prepaid tuition program. Every state sponsors at least one type of 529 plan, but many plans also function through private or public universities and colleges. The tax benefits and terms of of the plan vary from state to state, but we have generalized the following explanation to account for all different variations of a 529 plan.
Any U.S. citizen 18 and over can open up an account through a bank. The beneficiary of these plans tend to be a child, grandchild or someone under the age of 18. However, there are usually no age restrictions on who can benefit from the plan, so adults may open a plan for their own higher education expenses.
All 529 accounts are owned by one person and are allocated to one beneficiary. Multiple people can mutually contribute funds to the account as long as these funds don’t exceed the maximum contribution limit.
What is the difference between a savings and prepaid program?
A savings plan is similar to a 401k or IRA as investments are made within an individual account and can be paid through a variety of ways, depending on the contributor’s preference. Once the account is set up, the account holder choses from a variety of investment plans in order to oversee that their investment will grow over time.
Investment options usually includes stock mutual funds, bond mutual funds, money market funds, and age-based portfolios. Most investments in a savings plan are made through mutual funds. However, investments made through this type of plan are not guaranteed and are not federally insured.
Savings plans tend to be more popular than prepaid tuition programs because there is no age or time restriction for whom and when the funds can be spent. Unlike most prepaid tuition plans, savings plans cover all college costs, including tuition, room, board, and other living expenses. Also, this type of plan can be used at any college or university, regardless if it is an in-state or out-of-state public or private school. The caveat is that most savings plans come with various fees, such as advisor fees, management and program payments and other investment related expenses.
A prepaid tuition program allows the investor to buy tuition directly so that it can be used by the child in the future. These programs are either sponsored by the state or educational institution. Through this method, the account holder directly buys credit or units of tuition from the participating college or university. This usually does not include other expenses, such as room, board, and books, but the account holder may choose to include these specific expenses depending on their plan.
Investments are made at a fixed price, meaning the tuition value when first purchased stays the same when the funds are withdrawn. Unlike a savings plan, the value does not grow and thus may not reflect the increased tuition value when the funds are actually used. Also, most of these plans have a limited enrollment period and age/grade restrictions, meaning the money must be spent within a certain period.
How will this affect my taxes?
Although 529 plans are not federal tax deductible, the funds within the plan are not subject to state or federal taxes, which allows the account to grow over time. Currently over 30 states offer partial to full state tax deductions and some states will even offer matching grants to the investment. Also, once the funds are withdrawn, they can be spent on tuition and other costs without being taxed, as long as they are being used for college related expenses that are outlined in the original plan.
The principle, that is the original amount invested into the plan, will always be exempt from taxes and penalties because the investment was made after taxes were deducted. However, if money from the plan is withdrawn and funded towards a non-authorized expense, then those funds may become subject to federal and state taxes and up to a 10% penalty tax.
How can I open a 529 account?
It is crucial for parents to start saving for the child’s college sooner rather than later. This way, their college savings will begin to grow on a tax-deferred basis. An account may be opened directly through the state college’s program website. Another way is to start a plan with a financial advisor, who can help guide you through the different investment options and payment methods.
What are the advantages?
529 plans offer a variety of tax and financial benefits. These include:
- Growth. Allowing college investments to grow free of tax deductions.
- Potential state tax-deductions. Depending on the plan and the state, some states allow for tax-deductions that amount to the full or partial amount that the contributor has allocated to the plan.
- The primary account holder has the power to manage and withdraw funds. Also, the beneficiary does not have access to these funds until they reach college and then they may use the money to pay for tuition and other college expenses.
- The primary account holder may change the name of the account holder at any time. Also, funds that go unused by the beneficiary may be transferred to another 529 account without losing any of its tax benefits.
- Low impact on financial aid- Funds under these plans are viewed by the federal government as parental assets. Meaning, only 5.6 percent of the plan’s assets will be calculated into the federal financial aid formula when the institution or federal government determines the amount of federal aid a student may be qualified for.
- Financial support. A 529 plan is a smart and efficient way to start planning for your child’s future and making sure that the financial burden of paying for college is lessened when the time comes to make tuition deposits.
What are the disadvantages?
While 529 plans offer many benefits to the account holder and beneficiary who will eventually be receiving the funds for their education, parents should be aware of the disadvantages when determining the costs and benefits of starting a 529 plan.
- The account holder will encounter administrative and investment fees when opening up an account. These fees are heavily dependent on the size of the fund and on the investment option that you select.
- Non-qualified withdrawal repercussions. The account holder will face tax expenses and penalties if funds are withdrawn for expenses that are not related to the education expenses outlines in the original plan.
- Time and residential restrictions. Those who chose prepaid tuition programs may have to use the funds within a certain timeframe or enrollment period. Also, some states mandate that an account holder must be a state resident in order to open up certain in-state account plans.
What are my other options?
There are several other college saving options that all have different contribution limits, federal and state tax effects, level of account control, and payment methods. For example, Coverdell Education Savings Accounts allow parents, grandparents, or other contributors to give up to $2,000 a year per beneficiary until they reach the age of 18. However, these are significantly smaller contributions than what 529 plans allow.
Uniform Gifts to Minors Act or Uniform Transfer to Minors Act allow for contributors of all income levels to create an investment account towards a beneficiary’s college education. The account holder can choose from a variety of investment plans are there are no limits to the amount of contribution. However, these funds are subject to federal and state income taxes every year and these funds may affect other financial aid as they are considered an asset to the child.
Bonds may be purchased to help finance a child’s higher education, but there is an annual maximum purchase of $10,000 for most bonds that are designed to pay for colleges and universities.
More traditional ways to pay for college include taking out a loan or applying for financial or merit-based aid. However, loans accumulate interest and can be a huge financial burden on the parent. Also, financial aid and merit-based aid have become increasingly competitive to receive as more students apply to and attend college each year.
Overall, there are several investment plans you may choose to set your child up for the future. Average college tuition has increased over 260% since 1970, according to Business Insider. This is mostly due to the large increased in college enrollment and the job market’s demand for higher degrees. Therefore, it is now more important than ever to start considering your best financial options for a college savings plan.
529 plans offer a great way for contributors to make larger investments for their beneficiary’s college and allow these funds to grow in a tax-deferred way. The details, benefits and fees vary by plan, but overall the funds in each plan will be protected from market fluctuations and downfalls and will be at the control of the account holder.
For more tips and details, visit https://www.sec.gov/reportspubs/investor-publications/investorpubsintro529htm.html to learn more about your state’s 529 plan offerings and limitations or contact a financial advisor to start saving for your child’s future today.