With tuition shooting higher and no end in sight, many students’, parents’, and grandparents’ minds may be turning to one question: “How will we ever be able to afford college?” There’s no magic formula for coming up with the tens of thousands of dollars you’ll need to send you or your child to school, but starting to save as soon as possible is as close as you’ll likely get.
Of the college savings plans available, the 529 plan is a favorite of financial advisors. 529 plans can give buyers the ability to lock in the current tuition rate and have appealing tax benefits. The plans vary from state to state; some may cover other states’ schools or they may restrict use to in-state public institutions. There is also a plan for private schools that restricts the use to participating universities.
Of course, there are plans besides 529 plans, though, so be sure to do your research to figure out which one is right for you. Consider the pros and cons, your timeline, and where you or your child wants to attend school to find the best fit for you.
The 529 Plan
The 529 plan, or qualified tuition plan, is named after Section 529 of the Internal Revenue Code that created these savings plans. There are two types of plans: pre-paid tuition plans and college savings plans. The plans offered differ from state to state but every state in the U.S. has at least one 529 plan.
Benefits of 529 Plans
The common ground for both types of 529 savings plans is that they are tax-advantaged. The earnings of these plans aren’t affected by federal taxes — or state taxes in many cases — if the funds are used for qualifying college expenses. Many states offer state income tax benefits or even matching grants for residents who take part in their state’s plan. You aren’t restricted to your own state’s plan, so research what kinds of benefits you can get in-state and out-of-state.
With 529 plans, you can also be exempt from five years of gift taxes in one year. For example, in 2013, you can gift up to $70,000 (the yearly annual gift tax exclusion amount is $14,000) to a 529 account and not be charged the gift tax, according to Karl Schwartz, a senior associate consultant with Hewins Financial Advisors.
These plans are also easily transferrable, Schwartz says. Did the beneficiary decide college wasn’t the right choice for him? Another eligible family member can be changed to the beneficiary without penalty. Ownership also stays with whoever opens the account, so the beneficiary can’t take over control just because they hit 18. The parent being the owner can be beneficial in financial aid calculations; while the account will be considered in the calculations, it will be assessed at a lower rate than if the account were an asset of the child.
And if you’re thinking about the estate planning aspects of these plans, the 529 is attractive. “From an estate planning point of view, they are not considered to be in the parent’s estate, which can save the heirs of wealthy parents quite a bit of money,” says Jason Papier, president of Fluent Wealth Partners.
The 529 plan can generally be used for students of any age and has very high contribution limits. Some states allow as much as $310,000 in an account.
The pre-paid tuition 529 plan has unique benefits and drawbacks that can make it a great fit for some and a waste of money for others. Consider them as you choose between the two types of 529 plans and other available options.
Pre-paid tuition 529 plans allow you to lock in tuition at the current rate. You can purchase a percentage of tuition at today’s rate and use it for the same percentage of tuition in the future. If you put in $10,000 today and it covers one year of college at today’s rate, it can be used in the future for one year of college tuition, even if it has risen significantly.
Drawbacks of 529 Plans
Though Schwartz says that of the options, 529 plans are the “most common and a great college savings tool for the average person who wants to put aside a modest amount of funds,” there are some negative aspects. It is an education savings plan, so using it for anything else can void most of the benefits. Depending on the plan you have, some restrictions are tighter than others. Most plans cover tuition and housing. Pre-paid plans are generally a little more limiting, and funds can’t be used for supplies like computers. The savings plan, on the other hand, may allow for textbooks, supplies, and computers. Things like repayment of loans, transportation, and entertainment are not covered. If you use your plan improperly, you’ll be subject to income tax and an additional 10% federal tax penalty on earnings.
As we mentioned, 529 plans are considered in financial aid calculations. It can be beneficial for a parent to own the account, since it may be given less weight than if a student owns it. Grandparents as owners can be tricky, though. Grandparent-owned assets aren’t required on financial aid paperwork, but can affect the student’s aid in the future. For example, if a grandparent pays for the student’s first year of tuition, contributing $30,000, the student is set for the first year, but the next year, the gift can hurt them. “Grandparents are not always aware that the $30,000, in this instance, gets added as student income on next year’s financial aid form, which may disqualify them from some or all of their previous financial aid amounts,” explains Peter Donohoe, a financial planner with PRW Wealth Management.
He recently worked with a client on this problem and found the parents to be the best solution. “We explored several options and in this case, we ended up transferring the ownership of the 529 account to the student’s mother,” he says. “The 529 would make it onto next year’s FAFSA form but with much less weight as a parental asset.”
While locking in tuition rates is an exciting advantage of choosing the pre-paid 529 plans, there are often restrictions on where you can use your funds tax-free. It depends on the exact plan that you invest in, so make sure you understand how your money can be used. Some states will only allow their pre-paid plans to go toward undergraduate schooling at the state’s public institutions. The Private College 529 Plan is eligible for use at the more than 270 participating private colleges and universities, but those are the only choices for this very important decision. Some may be able to be rolled over into something that the beneficiary can use for any school, but be sure to read the fine print before purchasing.
Other Savings Options
The 529 plans are great options, but when researching something as important as financing the education of you or a loved one, it’s important to know what’s available to you. Just as no single college is right for everyone, no single college savings plan is perfect for everyone’s financial situation. Consider the pros and cons of these savings options.
- Taxable accounts: Savings accounts that aren’t college-specific are good options for many people who aren’t sure if their child will go to college. The money invested and earned can be taken out for any purpose, including retirement, if it isn’t used for higher education. The benefits and consequences depend largely on the type of account you invest in. Mutual funds allow you to invest in a diversified package of stocks and investments, and because they are managed by a specialized company, you don’t have to have much knowledge of investments personally. The taxes on mutual funds (even when you lose money) as well as the fees required to manage them can make them less appealing to some investors. Savings bonds, another type of taxable account, are a very low-risk investment with no fees for a broker and low taxes that don’t have to be paid until the bond is cashed in. The interest earned on savings bonds, however is very low. (If savings bonds interest you, the Education Savings Bond Program is a potentially tax-free option.)
- Coverdell Education Savings Account: The Coverdell ESA allows parents and students to put away money for both higher education, as well as primary or secondary education. As long as the funds are spent on qualified educational expenses, these accounts are tax-free, according to Schwartz. The potential downsides are that the annual contribution limit is $2,000 for the beneficiary, severely limiting the potential for large savings, and there are contribution limits based on income. When the beneficiary turns 30, if there is still money in the Coverdell ESA, it has to be distributed within 30 days, but it can be transferred to another eligible family member.
- UGMA/UTMA Custodial Account: The Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act allow adults to transfer assets to minors. These accounts aren’t reserved strictly for education purposes but are often used for college savings because there are no contribution limits, funds can be invested however the owner wants, and the “custodian” or parent has control until the minor turns 18 (or whatever the state’s law says). However, there are no tax breaks on these accounts and taxes must be paid on earnings annually. When the minor turns 18, he or she automatically takes control of the account, which is counted as the student’s asset in financial aid calculations. Schwartz advises that this type of account may be best as a supplement to a 529 account to achieve a higher balance or more flexible spending.
- When should I start saving? “Start saving ASAP,” Papier says. “I advise people to do $25 a month to start with, if they can’t do more. Then, with every raise, add a little more. It adds up. The costs of waiting are huge.”
- How much should I put away? This depends on your family and financial situation. Consulting a financial advisor is best, but this is how Papier advises clients: “My answer depends upon the person and the children. If there are multiple children I always suggest they maximize their contributions. If they can pre-pay the first five years in the first year (the 529 rules allow you to do this), then I suggest they do it. The money can be rolled from one child to the next, so there is little worry about having too much. If they’re going to do monthly then we figure out the age of the child, how much the parent wants to ultimately save, and then do the calculation to tell them how much to save per month.”
- How do I choose a plan? Talking with a professional financial advisor is always a good answer, but you can also do research on your own. Savingforcollege.com is a great resource to start with. It allows you to compare plans, understand them better, and use tools and calculators that will help you decide how much to save and what will work best for you.
- Which state has the best plan? Since the 529 plan varies between states, it’s often asked which state’s is the best. “The answer sometimes depends on what state the individual is a resident of but we have our favorites based on factors such as investment options, investment quality, overall cost, and past history,” Schwartz says. Each year, Morningstar names the 529 plans they have the most confidence in. For 2012, the Gold-Rated plans came from Alaska, Maryland, Utah, and Nevada. If your home state doesn’t offer great benefits, turning to one of these states for the 529 savings plan might be a better choice. Note that pre-paid plans can only be taken out in the state in which the owner or beneficiary resides.
Whether you’re a parent, grandparent, or student hoping to save up some money for college, there’s no better time than right now to start putting money away. The 529 plans are great options for many people looking for a tax-advantaged savings plan, but before committing to such an important decision, it’s essential to do your research. Consider your state’s benefits, your overall goals, how much time you have to save, and how your savings may affect your financial aid offer. Saving for college is achievable. The sooner you start, the better.