Luke

That’s Luke, my 18 month old son who will one day go to college. From what I’m told, I’m going to blink an eye and the next thing I know I will be sending him off to college.

Yes, I am already thinking about my son’s college education.  Here’s why:

According to a simple financial calculator, a university that charges $30,000 for tuition a year today will cost approximately $68,761 by the time Luke has graduated high school (per year).

Total cost of tuition my wife and I will pay for all 4 years of Luke’s college education will be $296,367 . Yes $296,367

To put it in perspective, in 1999, when I went to college, tuition was $98,000 in total and when my father went to college in 1966, tuition was $20,000 in total. Wow, what an increase!

Financial Planning:

As his parent I feel it is prudent for me to try and save for his college education. Whether I can save the full amount today or not is irrelevant, this post is really about the vehicle that I think is best to save for college related expenses for most people.

That is the 529 plan.

529  Plan

What is it?

A college savings plan is a type of qualified tuition program (the other type is a prepaid tuition plan) established under Section 529 of the Internal Revenue Code. College savings plans are established by states and typically managed by an experienced financial institution designated by the state.

A college savings plan lets you save money for a child’s college or graduate school education in an individual investment account. Although the details of college savings plans vary by state, the basics are the same:

The Basics

• You, a grandparent, or anyone else open an account with a particular plan and name someone as beneficiary. The beneficiary does not need to be related to you.
• Once the account is open, you (or anyone else) can contribute as much money to the account as you wish, subject to the plan’s specific limits. Some plans may require a minimum amount to open the account or a minimum amount per contribution. Plans may also restrict the total contributions allowed in one year. All plans have total lifetime contribution limits.
• When you make a contribution, your money goes into one or more of the plan’s investment portfolios (each portfolio typically consists of several mutual funds). Depending on the college savings plan’s specific rules, you either select your investment portfolio at the time you open your account (in which case you can consider your risk tolerance and time horizon) or you are automatically assigned an investment portfolio based on your child’s age (called an age-based portfolio). With an age-based portfolio, the portfolio’s investments automatically grow more conservative over time as your child ages.
• Your rate of return depends on how your specific investment portfolio performs. There is no guaranteed rate of return. The plan’s professional money manager (designated by the state) is responsible for controlling the assets that make up each investment portfolio
• When you need funds for the beneficiary’s college or graduate school expenses, you notify the plan administrator that you’d like to make a withdrawal. Funds in your college savings plan account can be used at any college in the country or abroad that is accredited by the U.S. Department of Education.

Note:

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated.

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The Strength of the 529 Plan

Contributions grow tax deferred

The money you contribute to your college savings plan account grows income tax deferred at both the federal and state level. This means that instead of paying income tax each year on the money the account earns (if any), income taxes are deferred until the time you make a withdrawal.

Withdrawals used for the beneficiary’s qualified education expenses are income tax free at the federal level

Earnings on money invested in a college savings plan are completely free from federal income taxes if the funds are used to pay the beneficiary’s qualified education expenses. (But contributions aren’t deductible at the federal level.)

Contributions receive favorable federal gift and estate tax treatment

Contributions to a college savings plan are considered completed, present-interest gifts for federal gift tax purposes. This means that they qualify for the $14,000 federal annual gift tax exclusion. And by making a special election, you can contribute up to $70,000 in a single year and spread the gift equally over five years to avoid gift tax.

States may offer their own state tax incentives

In addition to the federal tax benefits, states are free to offer tax incentives on college savings plan contributions and withdrawals. Examples include a deduction for contributions, an income tax credit for contributions, or a full or partial exemption of earnings from state income tax when a withdrawal is used to pay the beneficiary’s qualified education expenses. However, some states may limit their tax benefits to individuals who participate in the in-state college savings plan.

Funds can be used at virtually any college

The money in your college savings plan account can be used to pay for tuition, books, equipment, fees, and, if the beneficiary attends school at least half-time, room-and-board expenses at any college in the country and abroad that is accredited by the U.S. Department of Education. This includes a wide variety of schools–undergraduate colleges, graduate and professional schools, two-year colleges, technical and trade schools, and foreign colleges. This is a notable advantage over prepaid tuition plans, which typically offer maximum benefits only if your child attends an in-state public college or a college that otherwise participates in the prepaid tuition plan.

Participation is not restricted by income level

College savings plans are open to all individuals, regardless of income level. This is a distinct advantage over Coverdell education savings accounts, which limit participation based on income.

Total lifetime contribution limits are high

The total amount you can contribute to a college savings plan is high. Most states generally have limits over $300,000.

Opening an account is easy

It’s simple to open a college savings plan account. You fill out a short application, designate a beneficiary, and contribute the required minimum amount. Most plans offer automatic payroll deduction or electronic funds transfer to make future saving even easier.

Most college savings plans are open to residents of any state

All states offer college savings plans, and the majority of plans are open to residents of any state. This means you can shop around for the plan with the best money manager, overall performance record, investment options, fees, and customer service. But keep in mind that many states limit their tax benefits to residents who participate in the in-state college savings plan.

You have a rollover option once every 12 months

You can roll over your existing college savings plan account to a new 529 plan account (college savings plan or prepaid tuition plan) once every 12 months without any federal tax penalty and without having to change the beneficiary. (But the state sponsoring the plan may impose a cost or penalty, so check the plan’s rules before you do the rollover.) This option lets you leave a plan with few investment choices or one that has earned poor returns for a plan with more investment flexibility or a better track record

Tradeoff’s

If you’re a college investor, college savings plans offer more advantages than disadvantages. But there are some tradeoffs.

Returns aren’t guaranteed

A college savings plan doesn’t guarantee you a minimum rate of return and you are subject to market fluctuations.

Limited ability to change investment options on existing balance

If you’re unhappy with the investment performance of your current investment portfolio but don’t want to switch plans completely (like the rollover option described above), college savings plans are federally authorized (but not required) to let you change the investment options on your existing contributions twice per calendar year.

Withdrawals not used for the beneficiary’s qualified education expenses are taxed and penalized

If you make a nonqualified withdrawal–a withdrawal used for something other than the beneficiary’s qualified education expenses–the earnings portion of the withdrawal will be taxed at the federal level at the rate of the person who receives the distribution. State taxes will likely apply, too.

The plan’s investment portfolios are managed exclusively by the plan’s money manager

Though you may be able to choose your investment portfolio at the time you open a college savings plan account (or else one will be chosen for you based on your child’s age), you can never choose the portfolio’s underlying investments. This job is solely for the plan’s professional money manager, who is designated by the state. If you’re unhappy with your portfolio’s investment performance, your only options are to rollover your account to a new 529 plan or to change your investment option if your plan allows it (see the Strengths section above).

In my opinion the strengths heavily outweigh the tradeoffs.  I understand there is a lot of info here to take in regarding 529 plans.  To clarify some more points,the two most common questions I get when discussing college savings with clients are:

What if my child gets a scholarship?

What if my child decides not to go to college?

Because you will probably have the same ones here are the answers:

Your child got a scholarship to college–now what?

If your child receives a college scholarship, you can withdraw–without penalty–funds in your 529 account equal to the amount of the scholarship. As long as your withdrawals during the year don’t exceed the amount of the scholarship for the year, you will not owe a penalty.  Withdrawing the funds isn’t your only option. You can leave the funds in the 529 account for your child’s future, possibly graduate school expense. Or, you can change the beneficiary of the 529 account.

What happens to the funds in your 529 account if your child doesn’t go to college?

If your child decides not to go to college, relax–you’ll have several options. First, you can leave the funds in the account. It’s possible that your child will change his or her mind about college at some point in the future.

Second, you can change the beneficiary of the 529 account to another family member who will use the funds for college. And finally, you can withdraw the funds and use them for any purpose you choose.

The drawback to this option, though, is that you may owe a 10 percent federal penalty tax on the earnings that have accumulated (a state penalty may apply as well). You may also owe federal, and in some cases state, income taxes on the earnings that you withdraw.

In the end

Saving for college is not something to be taken lightly. You have to evaluate all of your goals and properly prioritize them.

The 529 plan could be an excellent option to save for those future education expenses. I would be happy to discuss your situation to see if this makes sense for you.

Look for future posts on the best ways to save for your retirement  and check out my recent post on  financial wisdom!

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Thanks for stopping by and I hope you achieve financial success!