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Saving for College

By: Chris Sargent, CFP®, C(K)P

At some point during my time in college, the tuition rate at the university I attended hit $400 per credit hour.  At the time I remember thinking, as a naive young person, that that was a lot of money.  And then I promptly forgot about it and went back to living my life.  Almost 20 years later, I have a son that is starting to think about where he'd like to go to school.  My alma mater is now past $1200 per credit hour, for an annual inflation rate of well over 6%.  That's almost three times the general rate of inflation over that same period of time, but is actually more or less in line with higher education around the country.

If you are among the millions of parents who want your kids to grow up and get a college education (assuming you have settled in your own mind whether you think college is worth it), you have probably spent a little bit of time googling around to find out how to save for that purpose.  Let's talk about a 529 account, which despite being introduced in 1996, is still largely unknown by Americans

For most people, a 529 account probably should be the number one option for saving for college. Each state operates its own 529 plan and makes its own rules for the plan, so maximum contribution levels vary across states. Potential contributors should check with the state to determine specific investment maximums. The maximum contribution limit applies to beneficiary, not the individual making the contribution. So mom, dad, grandma, and grandpa can all contribute that amount each year to a 529 set up for Little Brother and the same for another 529 to Little Sister.  No one gets a tax deduction for money contributed to the 529 account, but any gain on the investments inside the 529 grow without incurring taxes.  You can contribute more than $15,000 annually.  One option is to "superfund" the 529 with an amount up to five times the annual limit ($15,000 x 5 = $75,000 per donor, per beneficiary), and then not make another gift for 5 years.  Another option is to just add however much you want to the 529 and if it's over the $15,000 limit you simply file a federal gift tax form and deduct the excess from your lifetime gift tax exclusion.  If you have questions about that, it's best to visit with your tax advisor or CPA.

When funds are taken out to pay for qualified expenses, there is no tax due.  Those two factors can make for an extremely powerful combination if you can start early enough in the child's lifetime.  529 assets are most obviously used to pay for college tuition, room and board, books, and fees.  However, there are some less obvious, but just as helpful, ways to spend those funds.

  • Computers, printers, and internet access.  Upgrade your student’s technology before they go off to school (or start their next semester of online classes).
  • Graduate school.
  • Vocational/trade school.
  • Apprenticeship programs that are registered with the Department of Labor.  It’s not only manual trades like electricians and carpenters.  How about being an Army National Guard intelligence analyst or a cloud cybersecurity engineer?
  • Student loan payments, once your college grad is out of school.  Up to $10,000 a year.
  • Public, private, or religious K-12 school.  Up to $10,000 a year.

If you use 529 assets to pay for a non-qualified expense, you’ll have to pay state and federal income taxes and an additional 10% federal tax penalty on earnings.

Typically a 529 is started by either a student’s parent or grandparent, and if your student will be applying for federal aid it actually does matter who the owner is.  If a parent or the student herself is the owner of the plan, the value of the 529 is counted as "parental assets" on the Free Application for Federal Student Aid (FAFSA) and a portion of the plan's value goes towards the Expected Family Contribution (EFC) calculation.  A higher EFC means less financial aid.  However, any distributions from the 529 plan for the student's education expenses are not included in the income calculation on the FAFSA, which is a favorable.  If the 529 account is owned by the student's grandparent, the opposite is true: the value of the 529 account is not included in the as part of the EFC, but any distributions from the account are treated as student income, which negatively impacts the financial aid the student would otherwise be eligible for.

The ability to change beneficiaries, typically limited to once a year, is one of the best aspects of 529 plans.  The beneficiary is the person who can receive a 529 distribution with no tax consequences.  There is also no tax consequence for changing beneficiaries as long as it’s to another family member of the current beneficiary, and in some cases it is highly desirable to do so.  “Family” is pretty broadly defined, too: parents and siblings, step-parents, step-siblings, first cousins, in-laws, spouses of family members, and foster children all count.

One other interesting aspect of 529 ownership is that funds gifted to the 529 are removed from your estate, but you still retain control of them.  This is a unique situation that potentially provides some additional benefits for grandparents and high-earning parents.  Again, discuss with your attorney and financial advisor if you'd like to know more.

To open up a 529 plan, you can go online and look through the options to open an account, or speak to your financial advisor who can help narrow down the options for you.  You do not have to choose a plan offered specifically in or for your state of residence, or the state in which your student wants to go to college.  Some states offer state income tax credits if you live in the state and contribute to the 529 for that state.  Texas, which has no state income tax, obviously does not provide that benefit.

Disclosure:

Prior to investing in a 529 plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.

It is important to understand the fees and expense associated with 529 plans because they lower your returns. Fees and expenses will vary based on the type of 529 plan (education savings plan or prepaid tuition plan), whether it is a broker or direct-sold plan, the plan itself and the underlying investments. You should carefully review the plan’s offering circular to understand when fees are charged for the plan and each investment option.

Potential tax benefits are subject to federal and state income taxes and laws that affect 529 plans, which could change. You should make sure you understand the tax implications of investing in a 529 plan and consider whether to consult a tax advisor.