Sure, you’ve got your retirement plan all set up for that big day – but what about your kid’s college education? Have you saved up for it?
More than that, there are still a lot of other questions you need to answer. How much will the total college expenses be? Can you use that college money to reward yourself and your wife with a new car?
The answer to these questions will depend on where and how you’ve set aside your money.
Fortunately, there are many ways to save for future tuition costs and one of them is opening a 529 college savings plan.
What Is a 529 Plan?
A 529 plan works like a Roth IRA that takes care of education expenses instead of retirement.
It provides you with tax breaks when you use the money for qualified education expenses such as tuition, school fees, books, and other supplies.
Expenses for room and board also qualify under the plan.
You can make your contributions to a 529 plan after-tax but some states will allow you to deduct your contributions for state income tax purposes.
The great thing about a 539 plan is that the funds inside it will grow tax-free and you also won’t pay taxes for withdrawals if you used them for qualified education expenses.
However, if you withdraw money for any other purpose, you will pay taxes on the earnings plus a 10% penalty.
In a 529 savings plan, you can invest your contributions in a pre-selected set of mutual funds. This is much like what they offer as investment options within your 401(k).
You will see that your balance increases or decreases depending on your contributions and how the investments perform.
At any time, you can use the money in your account to pay for qualified education expenses.
It is the state government that sponsors the 529 plan. This means that the state sets up the plan with an asset management company that it chooses.
The employee then opens a 529 account with that asset management company under the state’s predetermined plan features.
You, as the holder of the plan, is the owner of the account while the child for whom you’ve set up the account is the beneficiary.
All transactions happen between you and the asset management or investment company and not with the government.
As in any other regular investment, a 529 plan comes with the inherent market risk so don’t think that the state will guarantee your money.
The Annual Contribution Limit For 529 Plans
One unique feature of a 529 plan is that the IRS does not specify an annual contribution limit for it. In fact, many 529 plans offer high or no limit total contribution limits.
Every state manages its own 529 College Savings Plan so there could be different guidelines for maximum contributions for each state.
Since the 529 plan aims to help the plan owner cover college expenses, the state sets a reasonable maximum that already takes into account all possible education expenses.
These would include undergraduate tuition and fees, books for students, laptops, etc.
In some situations, room and board can become eligible expenses.
However, personal and travel expenses do not qualify as such. And since the funding includes graduate tuition and other costs, 529 plan maximum contributions can run up to $200,000 or more.
But don’t be too quick to contribute the maximum to your 529 Savings Plan.
It may be appealing but consider the other factors as well, such as the tax consequences for the account holder and other donors.
Here are some things to think about before making a huge contribution to a 529 Savings Plan.
529 Plan Benefits
One outstanding benefit of the 529 plan is that you can enroll in any state’s plan regardless of which state you live in.
But remember that you can only enroll once in 12 months. That gives you flexibility and freedom of choice.
In the area of investing, the plan allows you to change your investment options twice per the calendar year.
Another thing is, once your beneficiary has completed an undergraduate degree, you can use any remaining funds in the plan toward graduate, trade or vocational education at any point.
You also have the right to reassign a 529 plan to any direct relative.
Withdrawals Are Tax-Free
The tax benefits are what make 529 plans very attractive to people. You can invest money tax-free and withdraw money for education expenses without paying taxes.
To avail of the tax-free withdrawals, you should use the money you will take out from the 529 plans should for a qualifying expense.
These cover tuition costs or associated schooling costs that the state government, state agency, or oversight organization responsible for the plans list down.
But since the tax laws can change over time, it would be good to review the current tax provisions in your state before making a withdrawal.
Choose How To Invest
There is a high level of flexibility in a 529 plan because it affords a variety of investments.
You can have your choice of mutual funds, exchange-traded funds and fund of funds portfolios.
Most plan managers will invest the money you contribute to the plans through index management to make sure that you receive some type of return.
Some plans take a different route and allow you to make direct investments. Others will offer different generic plans for you to choose to invest in.
A 529 plan is very transparent so that you always know where your money is going. But to be sure, always ask for the details before you agree to any 529 scheme.
You will notice that the majority of them will offer risk-based or age-based options just like target-date funds that you find in a 401(k) program.
Flexibility Within The Family
Supposing that the original beneficiary does not go to college at all or doesn’t use up all the funds in the plan, the plan owner can change the beneficiary to a family member of the original beneficiary.
A 529 savings plan does not specify a deadline as to when you should use the money.
If there is some money remaining in the account, you can avoid taxes and penalties by continuing the plan and designating it for a different beneficiary.
This flexibility is a good thing because if you don’t use the money for higher education, the government will assess you a higher tax.
The definition of “family member” is broad in this sense. The potential to allow the owner of 529 savings plans to use it for more than one student or even for succeeding generation is very noteworthy.
Anyone can start a 529 savings plan and anyone can contribute to the plan – it’s that convenient.
Can you imagine if you have a family where all the members want to contribute? This is a wonderful way to help out.
For those who are generous and want to make larger contributions of $15,000 or more in a year, they can use the plan’s unique 5-year gifting feature.
It lets you make gifts of up to $75,000 (5 years’ worth of gifts) without taxes. Married couples who are filing jointly can combine that limit and contribute as high as $30,000 per annum, per child.
They can even contribute five times that amount in one year without worrying about gift tax repercussions.
Possible State Income Tax Deductions
Currently, you cannot deduct your 529 plan contributions for federal income tax purposes.
However, there are presently more than 30 states that offer a state income tax deduction, and some of them don’t even require you to contribute to your home state’s plan to qualify for it.
If you happen to live in one of those states, that deduction can translate to a bigger contribution because of the tax savings you realize.
529 Plan – The Cons
People may think that a 529 plan is all advantages. There are also some potential drawbacks that one should look out for.
Like many financial products, a 529 plan carries its own set of fees.
It’s quite complicated to sort through them but they break down into different advisor fees, program management and maintenance charges, and underlying investment fees.
From a perspective of cost recovery, your investment dollars have to work double-time to generate enough returns to cover the fees.
Limited Investment Options
Although there are similarities between them, a 529 plan works very differently from a traditional savings account.
Instead of just earning interest, money that accumulates in a 529 plan is investible, usually in mutual funds although you can get a plan that offers exchange-traded funds or individual stocks.
That is a considerable advantage because a market investment yields higher returns than simply earning interest.
With the power of compounding interest, as your money grows over time, your fund has an opportunity to grow faster.
What could be a show-stopper is if you choose a plan with less flexibility in its investment offerings. A limited investment option could curtail your diversification strategy.
Limited to Education Expenses
The major disadvantage of a 529 plan is that if you don’t use the money for qualified education expenses, your withdrawals become subject to tax.
You also open yourself to a 10% penalty.
There are exceptions for scholarships, of course. However, just looking at that scenario, the penalties should make you think twice about over-contributing to a 529 plan.
How To Open 529 Plan
You will find there are two types of 529 college savings plans. There are prepaid tuition plans and college savings plans.
In a prepaid tuition plan, you get a limited coverage of expenses but you already lock in future tuition rates at the current tuition rate for eligible colleges and universities.
On the other hand, a 529 college savings plan takes care of all qualified expenses that include tuition, room, and board, school fees, books, and computers, but don’t lock in the cost of tuition. This means that tuition rates will likely fluctuate.
Remember that each state has its own 529 college savings plan or plans. You are under no obligation to use your own state’s plans.
Also, take note that tax credits and contribution guidelines vary from state to state.
1. Shop Around
Many residents choose an in-state plan. But before you join the bandwagon, check if your state offers an income tax deduction for contributing to a 529 plan.
If that is the case, it is a financially sound decision to avail of the tax deduction from your in-state program.
If you live in an income tax-free state, then there’s nothing to discuss. You can concentrate on the fees, expenses and investment goals as the major decision points.
Some states with state-level income tax provide a tax break regardless of where the resident invests. Examples of these states are Arizona, Kansas, Minnesota, Missouri, Montana, and Pennsylvania.
There are only a handful of states that will not allow you to use their 529 plans if you are a non-resident of that state.
This gives you the liberty to shop around and check out the different plans of other states. Whatever 529 plan you choose, it will not affect where your child attends college so he/she can enroll in-state or out-of-state.
Of course, if they can have their way, states would rather that you use your college savings in-state.
This is why many states offer incentives to their residents.
It could be in the form of an income tax deduction for your contributions to the home-state plan, or matching contributions for residents below certain income brackets, or a waiver of some fees.
It’s up to you to choose your own state or go to a different state that has better offers.
Once you’ve picked a state, the next thing to decide on is whether you want an investment plan or a prepaid plan.
Maximize Your 529 plan
In the end, the goal is to maximize the total amount of money in the 529 plan account by the time the beneficiary is about to enroll in college.
It is important then, that families consider the 529 plan’s return on investment and costs aside from the tax benefits when selecting a 529 plan.
Minimizing costs is a key strategy to maximize your net returns. On top of fees and tax incentives, you should compare minimum contributions and investment options.
Historical performance does not matter much because it is a lagging indicator (rather than a leading indicator) of a plan’s strength.
It’s better to look for a plan with low costs. Countless studies reveal that cost is the best leading indicator of performance for diversified investments.
Try working with a financial advisor when picking a plan. Yes, there’s a fee for their services but you are after the convenience of having an expert figure it out for you.
2. Pick Your Plan
A 529 plan account would fall under two main types: individual accounts and custodial accounts.
The traditional way is to open an individual account where the account owner is a parent and the beneficiary is a child.
In a parent-owned 529 plan account, everybody can contribute – parents, grandparents, aunts, uncles and other relatives.
When it comes to ownership, only one parent can be the account owner. In case of divorced parents, the parent who will be responsible for filing the Free Application for Federal Student Aid (FAFSA) will be the owner.
Should this parent remarry, it is better than the account owner is the child’s biological parent and not the stepparent.
Check what other documents the plan will require because the plan managers will ask for a lot of additional information.
If you are personally opening the account, you can fill out a physical application form and send it thru snail mail.
However, most plans will let you do the application process completely online and just fund the 529 account by mailing in a check or transferring money directly from your checking account.
The process is very simple but you need to complete all the required paperwork or mandatory online fields.
Account Type Considerations
The only confusing part would be in the part where they ask you what kind of account you are opening.
The choices as Individual, UGMA/UTMA (which they also call “custodial” accounts in other plans), Trust Account, or Business/Other Entity. If you’re clueless about the last three, you’re opening an individual account.
Take note of this important matter regarding a 529 account ownership. You can find only a couple of plans that will allow joint ownership.
So, for married individuals, the spouse will not have access to the account unless they get a Power of Attorney.
Also, for couples with children from a prior marriage, the birth parent should appear as the account owner.
Many divorce processes have placed a child’s savings at risk because a vindictive spouse lays claim on the assets.
When you already make up your mind about a plan, read their program disclosure statement (PDS) to familiarize yourself with all the rules and terms.
Read the fine print so you know what you’re putting your money into.
3. Choose Investments
Whatever money you contribute to the plan will find their way into mutual funds or exchange-traded funds depending on the strategies of the financial companies that manage the fund.
Examples of these companies are BlackRock and iShares. They offer a different mix of funds for each plan option and you have the liberty of picking your plan with two approaches.
The first one is an age-based option that automatically adjusts your asset mix to assume less and less risk as the beneficiary approaches college age. This means that as you start, there will be more stocks in the portfolio and then gradually shift to cash and bonds as it matures.
Since stocks bring higher returns but carry higher risks, age-based options start out with a high percentage of stocks while the beneficiary is young.
As the student gets closer to 18 years old, it slowly switches to a more conservative bond and cash portfolio.
This systematic adjustment makes age-based tracks attractive to people who do not want the responsibility of managing the allocations in their 529 portfolios personally.
The second option is what they call the static choice. In this option, the owner holds an investment fund or group of funds that maintain the same allocation throughout the life of the plan.
Which Is Better For You?
Given the differences between these two umbrellas, people can still choose the plan that is most suitable for their risk tolerance or specific objectives.
Although stocks come with more risks, they offer higher returns than bonds. And bond choices are less volatile but they provide lower returns. But take note that not all bonds are the same.
Certain bonds are high-yielding but their risks and volatility level are more akin to stocks.
Some plans offer cash-like options in the form of principal-protected funds or insurance-backed guaranteed funds and even money market fund options.
If you are not comfortable with risky investments, these ones will be best for you.
Still, there is the inherent risk that these cash accounts may not be able to keep in step with inflation over time. Don’t expect them to deliver returns at par with a portfolio of stocks and bonds.
When you open a 529 account, there will be a program manager who will manage the fund.
Many times, the program manager would be a fund company or another financial institution but from time to time, it will be the state itself. They will invest your money in a custodial account under your name.
This means that even if the state or the fund manager encounters financial setbacks down the road, there’s protection for your money and immunity from these problems.
4. Deposit Funds
The earlier you begin putting in money to a 529 account, the more time there is for the money to grow.
For instance, if you contribute $100 a month into a plan for 15 years which earns a three percent return. (together with your $1,000 initial deposit), you could build up over $24,000 with the tax benefits.
As soon as you complete the physical application, mail it in together with a check – unless you are making a deposit using bank funds or other funding methods.
Within a few days to several weeks, they can complete the processing of your paper application.
In case there are any mistakes or missing information on the application, someone from the 529 plan will get in touch with you to correct the error or complete the information.
So, make sure that you provide sufficient details for them to be able to contact you.
If you’re applying online, the system will not let you proceed unless you have completely filled out all the required fields, so at least, there’s very little room for error.
Then, fund the account immediately by giving your bank information or by mailing a check using the data they have provided in the application materials.
If you mail the check, they will open the account and deposit the funds as soon as they receive them.
Alternatives to 529 College Savings Plan Contribution
If you would like to consider a different path than 529 plan, here are the main alternatives:
Traditional IRA or Roth IRA
You can consider using a traditional IRA or Roth IRA as a college saving even if they are traditional retirement vehicles.
With these IRAs, you can skip the 10% premature distribution penalty if you withdraw money before the age of 59 ½ as long as you use the money to pay for a child’s qualified college expenses.
If you have the time and can still afford it, invest in a Coverdell education savings account or a 529 plan that the state or an eligible educational institution maintains.
Each of these plans is for college education and comes with a handful of tax advantages.
In a savings account, you keep your money in a safe place (like a bank) where it earns minimal interest every month. They require either a low minimum or no minimum at all to open.
Of course, this will depend on the bank that you choose or the product they are offering.
If your savings account is money for college, you will be able to get higher interest in the long haul. This is because you will build up the fund for a longer time than usual as there are plans for 10 and 15 years, depending on your bank.
This is enough time to maximize the compounding of interest.
Your money is safer in a savings account because it has insurance. If you keep your money in your home and it burns down or robbers come in, you may lose your money forever.
But banks and credit unions keep your money in a locked and fireproof vault. They also insure your money with the Federal Deposit Insurance Corporation (FDIC) up to $100,000.
However, they are more flexible in terms of where the owner wants the money to go to and for what purpose.
While the balances in the account are for the benefit of the child, they are not exclusively for their college education.
Parents who are not sure if their child will go to college benefit a lot from this. Similar to the Coverdell, the owner has unlimited choices for investment options.
Withdrawals from UGMA/UTMA are subject to tax. But, they will use the child’s tax rate, which is at the lowest tier.
For those who are looking to use balances in these accounts for college tuition, you might lessen your ability to receive financial aid.
The government considers UGMA/UTMA account balances as assets but exempts 529 balances – so it’s more difficult to qualify for financial aid.
Coverdell Education Savings Account
One important feature of a Coverdell account is that your contributions and earnings grow tax-free as long as you use your contributions to pay for qualified expenses at eligible schools.
You can use Coverdell funds to pay for the student’s tuition, all associated fees, books, equipment, and supplies for their schooling at a qualified institution.
It could be any postsecondary school such as a university or college that’s eligible to take part in federal student aid.
You can also use Coverdell funds for reasonable room and board for those who fall under the category of half-time students.
One unique advantage of a Coverdell is that you can use it to pay for the educational expenses of younger students.
This covers children in kindergarten through grade 12 who are going to any eligible public, private, or religious school.
In fact, you will find more eligible expenses for younger students than for those who are getting a post-secondary education. You can use it for tuition, fees, books, supplies, computer equipment, etc.
Taxable Brokerage Account
One limitation of 529 plans is that the investment options are not very wide.
It wouldn’t have been bad if the investments performed excellently but that is not always the case.
If you’re the type of person who prefers more control over his investments, you can just get a traditional brokerage account and earmark it for college education purposes.
While you will give up the tax advantages of a 529, but you can have a free hand on where you want to invest the fund or how often you want to make them.
If you play it right, you could have a lower-cost investment (ex. index funds and ETFs) and higher overall return in the end.
Cash-Value Life Insurance
Policies for a toddler is not very expensive and given the longer time, the policy can build up a large cash value.
The premium that you pay goes to two main components: the cash value of the account and the death benefit.
Many policies will let you take out a loan against the cash value at a rock-bottom rate (if not zero percent) and you can use it to pay for school.
Don’t purchase life insurance exclusively for funding a college education. There is a cost to carry the policy but it can be a significant contributor in your education-funding strategy if you plan it correctly.
Yes, 529s are often an easy, convenient way to build up some college funds, they’re only one of the many choices you could take to finance an education.
Nevertheless, when it comes to a college education fund, the key is to start as early as possible to have more years for your contributions to grow.
College costs continue to rise each year and if you’re hoping to have substantial money for that massive tuition bill later, you’ll need as much time as you can get.