College Savings Basics: The 529 Plan

According to the College Board, the average cost of attending one year at a US four college (tuition, fees room and board) in 1989-90 was $9,030 for a public four year school, and $24,049 for a private four year school. Twenty- Five years later, the figures for 2014-15 have doubled, to $18,943 for public schools and $42,419 for private schools.

Even assuming that you could earn the same amount of return as the increase in tuition prices, parents would need to save $75,772 to fund 4 years at a public college. That breaks down to $4209.56 per year, or $350.80 per month, for 18 years.

If you want to help your child go to college while avoiding crippling student debt, saving early and often is your best bet. Starting early gives you more years to contribute. It also means more time for your money to compound before June or Junior head off to the ivy covered halls.

Enter The 529 Plan

A 529 plan is a tax advantaged college savings plan.  A 529 allows parents and others to put aside money, let it grow and compound, and then withdraw it tax-free for qualified higher educational expenses.

The 529 plan was created by Congress in 1996 and is the most common college savings vehicle.  The College Savings Plans Network March 2015 report put the number of active 529 plans at 12.1 million plans, totaling assets of $247.9 billion, at the end of 2014 with an average account balance of $20,474.

There are two basic types of 529 plan: the college savings plan and the prepaid tuition plan. Prepaid tuition pays for credits at participating colleges and universities at today’s prices. These are often guaranteed by the state in which they apply and usually have residency requirements,. Unfortunately, only 12 states have prepaid tuition plans. College savings plans are more common and more flexible, allowing a greater range of participants, expenses and investments.

Setting up the 529 Plan

It doesn’t take very much money to set up a 529 plan, and contributions do not have to be very high. You make contributions to 529 plans with after tax money, at least from the federal standpoint. Some states will even give you a tax break or even a match for contributions . Contributions can be made by anyone, but may be subject to the IRS’s gift tax restrictions if they exceed $14,000 for a calendar year. This means parents, grandparents and friends of the family can all make contributions.

Unlike an IRA, you can contribute to a 529 plan regardless of your income.

It is relatively easy to set one up through the state’s college savings program web site, as well as through most banks and brokerages. All 50 states and the District of Columbia offer 529 plans, though the investment options, fees, and conditions vary. Each state has different total contribution limits, and you don’t have to invest in a state’s 529 plans to use it in that state. Many states don’t have residency requirements, so you can use their 529 plan even if neither the owner nor the beneficiary lives in that state. You can move 529 plans to take advantage of better performance or lower fees, but only once per year. If you want to see how fees and expenses are affecting your 529 plan or to compare two 529 plans, you can use FINRA’s calculator.

529 plan generally limit investment options to cash, stock and bond mutual funds and ETFs. Most offer Target-date funds, which adjust asset allocation based on how soon the funds will be needed. Like IRAs and 401Ks, returns are not guaranteed and it is possible to lose money in a college savings plan.

Using the 529 Plan

529 plans can be used for tuition, fees, room and board, and required books at eligible educational institutions. Eligible institutions are the ones designated as eligible to receive student aid by the US Department of Education. If the designated beneficiary does not use the 529 plan for educational purposes, withdrawals are subject to income taxes and a 10% federal tax penalty. It is possible for a beneficiary to have multiple 529 plans, but contributions cannot exceed what is needed for the beneficiary’s qualified expenses.

If a beneficiary does not use all of a 529 plan, you can also change the designated beneficiary on a plan or roll unused funds over into the 529 plan of another beneficiary.  In order to do this, the new beneficiary must be a relative of the original recipient (child, stepchild, sibling, stepsibling, niece, nephew or first cousin). Beneficiaries can be any age, and you can set up a 529 plan for yourself if you plan on attending college or graduate school in the future.

If parents have set up a 529 plan and named their child as beneficiary, the plan will be included in the student’s need calculations for financial aid as parental assets for federal aid programs. If the student owns the plan, the plan is considered a student asset. Generally speaking, while parental assets are part of the need calculation, they are not as important in determining ability to pay as family income. Since student assets are weighted more heavily in student need calculations than parental assets, it is probably best to name the student as beneficiary but maintain the plan’s ownership with the parents.

Other College Savings Options

While 529 plans are the most common college savings plans, there are other options that may suit your financial situation better:

  • The Coverdell Education Savings Account has a $2000 annual contribution limit from all sources, but can be used for school expenses for K-12 students as well. There are income restrictions in order to contribute.
  • Roth IRA withdrawals used for qualified education expenses are not subject to the 10% penalty on early withdrawals and are not considered parental assets on the FAFSA.  This is useful if the beneficiary does not use all of the money for education, as you can still have the use of the funds as retirement savings.
  • Some parents set up custodial accounts for their children. These are taxable after the first $1050 in earnings, but can be used for any purpose and have no limits on contributions. They will be considered student assets, though, which means they count more than a parent-owned 529 plan in the student aid calculation.
  • You can buy US savings bonds for college savings. The ability to exclude the income from taxation is phased out at higher AGI levels.

This article is for informational purposes only. An investor interested in a 529 plan should proceed with caution and do lots of research before putting their money in any investment.

Image courtesy of hywards at FreeDigitalPhotos.net

 

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