How to Prepare for Your Child’s Future College Education
The rising cost of higher education has made saving for college one of the biggest concerns for many parents. Saving – whether started early on or just a couple years before college – is more important than ever before. Opening a 529 savings plan can be a great way to take advantage of tax benefits while building a college fund. However, many people don’t know what a 529 is or how it works. Learn more about this tax-advantaged savings plan to see if it’s the right option for you and your child.
What is a 529 Plan?
Named for section 529 of the Internal Revenue Code, a 529 savings plan is an investment account sponsored by states to pay for college and other higher education expenses. There are several reasons people choose a 529 over other savings plans, but its primary appeal is tax-free compounding. The investment earnings in the account grow tax-free, and when you withdraw to pay for a qualified expense, you won’t be taxed then either. And the longer you hold the money in the account, the greater the benefits. “529 plans give you tax-free income growth when the future withdrawals are used for qualified expenses,” explains Scott W. Johnson, owner of WholeVsTermLifeInsurance.com. Scott spends a lot of time explaining to his clients that there are better ways to prepare for college than a whole life insurance plan. “If you invest early, 529 plans may allow you to put in just 25 percent of the cost of education and yet have the whole thing paid for.”
How the Tax Reform will affect 529s
Under the new law, 529 savings can be used towards elementary, high school or homeschool expenses. Families will be allowed to withdraw up too $10,000 per year, tax-free. This is a benefit for parents who want to homeschool their child or enroll them in a private or religious school for K-12. While this sounds like a win, Forbes cautions there are things to consider before withdrawing funds to pay for K-12 education.
Who Needs a 529?
Anyone interested in building a college fund can open a 529 – parents, students, grandparents, friends or other relatives, and even charitable organizations. However, that doesn’t necessarily mean a 529 is needed. There are several ways to save for a college education and the right type of plan really depends on the beneficiary’s and/or account owner’s needs. A Roth IRA, for instance, is beneficial because it can also function as a retirement savings account, which means the investor can repurpose this money should their child decide not to go to college. 529s also vary from state-to-state, which may make other plans more appealing.
How Does It Work?
529 plans come in two forms – savings plans and prepaid tuition plans. States administer 529 plans, which means the options and incentives offered can vary across borders. Prepaid tuition plans are generally less common, but this type of plan allows you to make an up-front payment for the cost of attending an in-state public college at the current tuition rate. This can be an ideal option if the cost of tuition is expected to rise by the time the beneficiary attends college. By contributing to a prepaid 529, the investor purchased tuition at a discounted rate.
If an investor is interested in opening a 529 savings plan, they will need to review and understand the benefits their state provides. “I suggest that most people look at savingforcollege.com to determine if there is indeed a need for you to use your own state’s 529 plan – for many states there is no advantage,” says Johnson. However, since some states do offer benefits for residents – for example, contribution matching for individuals under a certain level of income – it’s important for parents to be aware of all options before making a decision.
529 Plans vs. Other Ways to Prepare for College
A 529 plan might be perfect for one family or student but it might not be the best option for another. To help you make an informed decision, here’s an overview of other common ways parents can start building their child’s college fund:
The Coverdell Education Savings Account (ESA) is similar to a 529 plan in that it allows for tax-free investment growth and tax-free withdrawals, so long as funds are used for academic expenses. Unlike the traditional 529, however, an ESA can also be applied to K-12 education. The account holder must also be within certain income limits and contributions are limited to $2,000 a year per beneficiary. According to Forbes, to realize the full benefit of an ESA in 2017, a parent needed to earn less than $95,000 (or $190,000 for married couples), after adjusted gross income plus tax-exempt interest income.
Pros
- Funds can be used for costs outside of postsecondary learning
- More investment options
- Beneficiaries can be changed at any point
Cons
- Johnson notes ESAs have more restrictions than a 529 (e.g. who can invest in them and how much)
- Beneficiaries must utilize funds before they turn 30, which can affect students looking to take time off after high school or students pursing a graduate degree
- ESA contributions aren’t tax-deductible
Provided all necessary income requirements are met, an ESA would be a good choice for parents interested in sending their child to a private pre-collegiate school. ESAs may also be beneficial for those looking for more investment options. With more options – ranging from stocks to real estate – investors may be able to achieve a greater overall payout than if they had opened a 529 plan.
A UGMA (Uniform Gift to Minors Act) account and a UTMA (Uniform Transfer to Minors Act) account are, for the most part, similar. Both are often used as college savings plans for a specified beneficiary, but the UTMA allows for the transfer of non-monetary assets, such as real estate, to a minor. Both types of accounts are managed in a similar manner, allowing for irrevocable transfers from any party into the account. Once a child reaches a specified age – typically 18 or 21 – they are granted full access to the account.
Pros
- Because the money isn’t required to go towards education, if a beneficiary doesn’t go to college, they’ll still have access to all funds
- UGMAs and UTMAs come with tax advantages dictating how the account’s initial deposits are taxed
- Open to people of any income level
Cons
- Beneficiaries cannot be changed after opening an account
- Investors may be required to pay taxes on earnings above a specified threshold
- The student may have more trouble receiving financial aid because the UGMA/UTMA account is treated as an asset of the beneficiary
Most financial experts agree a 529 offers more benefits than a UGMA/UTMA. However, if parents are interested in opening a savings account that allows their child to use funds however the child sees fit – for example, for a car payment – then the UGMA/UTMA may be a good option. Many parents that utilize this savings vehicle are also able to lower their taxable income.
Some individuals choose to open a mutual fund for college savings because it may yield a higher return compared to a 529 plan.
Pros
- May provide additional investment options
- Opportunity for higher return
Cons
- Withdrawals may be calculated into a student’s overall income, which can cause problems when applying for financial aid
- Once a child’s investment income exceeds a $1,700 threshold, they can be taxed at their parent’s rate, often referred to as “Kiddie Tax”
- An investor has less control over investment decisions
- Year-end capital gains may be taxed
According to many financial advisors, there are rarely situations when investing in a mutual fund is going to be the better option than a 529 plan. Mutual funds come with more risks, and many parents are more interested in the safest investment option when it comes to their child’s educational future. However, if parents are interested in allowing their child to access their returns for something other than college, a mutual fund may have some merit.
Benefits of 529 Plans
According to Johnson, 529 plans are often the best option for the average parent looking to save for college. The following are some of the benefits parents can expect to receive if they choose to open a 529 savings plan:
Ability to change designated beneficiary
With a 529, it’s easy and to change the designated beneficiary, and there aren’t any tax consequences for doing so. “I like that if one doesn’t go to college, or doesn’t need the money, I can move the money for qualified expenses to another beneficiary,” says Dr. David Schein, who contributes to his three grandchildren’s 529 plans. This mobility can be ideal for parents with multiple children.
You can use an out-of-state 529
One of the common myths about the 529 is that an investor is stuck with the plan available in their home state. This isn’t the case at all. In-state residents usually qualify for certain benefits, but sometimes utilizing an out-of-state plan is the best and is indeed an option. “I live in Texas now,” says Schein, “which does not have an income tax, but I continue to contribute to the Virginia 529 plans for my first two grandchildren. For my third grandchild, my son in Maryland set up the 529, but also set it up in the Virginia plan since his research indicated that it was a strong plan.”
Greater account control
Some parents want to maintain control over the savings account to ensure funds are used as intended. With a 529, parents can do just that because unlike other savings plans – such as the UGMA/UTMA – the child doesn’t take over the account once they hit a certain age.
Tax-free earnings
Investment earnings aren’t subject to federal tax, and in most cases state tax, if used towards qualified education expenses.
Tax-free withdrawals
Schein said one of the reasons he prefers a 529 over other savings plans is because it offers tax-free withdrawals. So long as withdrawals go towards qualified academic resources – which now includes computer equipment – the investor won’t be taxed for accessing the funds.
Tax breaks and credits
More than 30 states also offer a tax deduction or credit for 529 contributions, up to the state’s limit. To find out if your state offers a deduction or credit, or to find out how much you could benefit from one, try using Vanguard’s 529 state tax deduction calculator.
Age-based investment options
Most 529s offer age-based investment options, meaning the asset allocation automatically adjusts over time. With this option, your 529 investments start out aggressive and switch to more conservative fixed income options as your child gets older and closer to the start of college.
Disadvantages to Consider
Despite the above benefits, 529s do have some disadvantages to consider, and it’s important to weigh the pros and cons before opening an account. Below are some of the drawbacks of utilizing this savings plan:
Non-deductible contributions
Although 529s offer many tax advantages, deductible contributions is not one of them. Any contribution you make to the 529 cannot be deducted from federal taxes, but, as mentioned above, certain states may offer tax deductions or credits.
Fees
While specific fees vary between different types of 529 plans, many have been known to charge account management fees that should be taken into account when considering a plan’s overall usefulness.
Non-academic withdrawals can be taxed
If funds are withdrawn and used for anything that isn’t a qualified education expense, the withdrawal will be taxed. If you only have one child, this is something to keep in mind. If your child doesn’t go to college and you don’t change the designated beneficiary to a prospective college student, any withdrawal will be taxed at a 10% federal penalty because the money won’t be used for a qualified education expense.
Limited usefulness of prepaid tuition
While Schein states that, “A prepaid tuition plan is great for someone that has enough funds to do so,” students may not be able to maximize their funding benefits if they decide to attend an out-of-state school. “Instead,” Schein says, “I contributed to the savings plan, which is very flexible.”
FAQs
How to Open A 529
Forbes reported the main reason people don’t open 529 accounts is because they don’t know how to. But opening an account is surprisingly simple. Here’s how:
Expert Tips to Maximize Your Savings
529 plans are a great way to reduce taxes and avoid penalties, but that’s only if you understand and follow all the rules from the start. Here are some expert tips to help you maximize your 529 savings:
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Know your Qualified Higher Education Expenses (QHEE)
Only certain resources qualify for tax-free coverage with 529 withdrawals. Both parents and children should know what they can use funds for to avoid unnecessary taxation. Typically, these resources include tuition, books, housing and educational equipment.
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Make sure you understand the advantages
Because 529s are sponsored by states, each state can decide whether to offer a plan and what those plans will look like. As a result, rules, incentives and advantages will be different from state to state. Before opening an account, compare plans and once you’ve decided on one, make sure you understand all the details.
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Minimize consultation fees
Parents are either able to set up their 529 account on their own, or work through a financial advisor. While meeting with an advisor has its benefits, taking a more independent approach can be a better option for those who want to maximize their savings.
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Get started early, if possible
While parents are can open a 529 when their child is older, it’s recommended to get the earliest start possible to maximize savings. According to Johnson, some 529s allow plans to be started even before a child is born. “In this case, name yourself as the beneficiary,” he recommends. “You should be able to change this later.”
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Assess the initial deposit
Each 529 is going to have a different initial minimum contribution. For some plans, the initial deposit may be as low as $25, while others can be as high as $250. Be sure that the plan you select a will meet your expectations for an initial deposit.
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Invest wisely as the beneficiary ages
Investments can be risky, but depending on when an account is started, these risks may be worthwhile. “Since the grandchildren are so young, I selected a fairly aggressive investment option,” says Schein. More aggressive investment plans can yield higher results, but can also result in the investor’s nest egg taking a hit. As students age, however, an investor can adjust how aggressively they want to invest.