There’s been some talk during the current presidential campaign about making public colleges tuition-free. It makes a good soundbite but it’s not going to happen anytime soon. College tuition will remain the second largest personal expense after one’s home. That’s the bad news. The good news is that there’s a simple, low-cost, tax-deferred way to save for college: the 529 Plan.
Named after a section of the IRS code, 529 Plans were introduced in 1996 and held $253 billion in savings at year-end 2015.
Their popularity is due to their simplicity and flexibility. 529 Plans are available from a wide range of mutual fund companies, insurance firms, and brokerage houses. The application is straightforward and brief. The account value grows tax-deferred from the moment a contribution is made until it’s withdrawn. Qualified withdrawals are actually tax-free and are not limited to four-year universities but also include community colleges, technical and vocational schools, as well as part-time and night-school studies. The money can be used by anyone you designate as beneficiary (including yourself).
As with most investing strategies, 529 Plans should be established as early as possible in order to reap maximum benefit from the tax deferral as well as compounding of returns.
Most parents wait until the birth of a child to begin saving, but some prospective couples have opened 529 accounts for unborn children by naming themselves as beneficiary and changing it when the child is born.
The Nitty-Gritty:
- Structure is similar to a Roth IRA: contributions are made with post-tax dollars, the account grows tax-deferred, and withdrawals are tax-free when used for educational purposes.
- Most plans have very low minimum investments so you can start with smaller contributions and increase them over time. The average family contributes $150 per month to each child’s 529 Plan. That’s just $5 per day.
- Contributions above $14,000 annually may be subject to gift tax. However – and this is a big however – the IRS allows you to front-load five years’ worth of contributions. That means each parent can contribute $70,000 (for a total of $140,000) and grandparents can do the same.
- The maximum lifetime contribution – from all parties – is $300,000.
- Each 529 Plan must have a designated beneficiary. However, the beneficiary may be changed at any time. So, for example, if your first-born receives a scholarship or chooses not to attend school, you can name your second-born as beneficiary. (You can actually name anyone as beneficiary. It does not have to be a family member.)
- Multiple 529 Plans can name the same beneficiary but have different owners. For example, a child’s parents and grandparents might own two separate accounts both of which name the same child as beneficiary. (See “Considerations” below about the sequencing of withdrawals from plans with different owners.)
- If the money is not used for educational purposes, it remains yours and can be withdrawn at any time. You’ll have to pay tax on the growth, but their tax-deferred nature makes 529 Plans an attractive investment for most people.
Considerations
- While every parent wants to ensure their children receive a quality education, saving for and paying for college should never be done at the expense of a secure retirement. That may sound a bit harsh and go against every parental instinct, but the reality is that you can borrow for school but you can’t borrow for retirement.
- 529 Plans should be viewed as one piece of your overall financial picture, not as a standalone investment. Most people would benefit from discussing the pros and cons with a financial professional. (Keep in mind, however, that advisors may not be able to offer all plans.)
- As with all investments, expenses are a key consideration when choosing a 529 Plan. Our firm believes the Vanguard product offers the best value. You can visit Morningstar.com to compare the features and costs of all 529 Plans.
- Some states allow 529 Plan contributions to be deducted from taxes. Make sure to see if this applies to you before selecting a plan.
- In addition to a 529 Plan, some states like Massachusetts offer pre-paid tuition plans. These plans tend to be less popular due to the constraints on what colleges are included.
- Recent changes to the Federal Financial Student Loan Application (FFSLA) have affected the calculation of a family’s expected contribution to college expenses. Because of this, it could be beneficial to draw down a parent-owned 529 Plan early in the student’s college career and hold off withdrawals from a grandparent-owned account until the student’s junior or senior years.
Every family’s situation is unique, so we encourage you to contact us with specific questions about how best to save for your children’s or grandchildren’s education.
