It is that time of year again where kids are heading back to school and you are now one year closer to having your child go off to college making the expense of college that much closer. While saving for college is a major concern for parents and even grandparents, understanding how to save efficiently and profitably is not so obvious. Savings options can include gifting appreciated securities, holding investments in taxable Uniform Gift s to Minors Act (UGMA) accounts, savings bonds and 529 College-Savings Plans. Of these options, 529 plans can be a great choice for many reasons:
- Contributions can be done over many years or in a lump sum.
- Contributions are gift ed to the plan and a person can give up to five years worth of gift s at once (five times the annual $14,000 exclusion).
- Assets in the plan are not taxed.
- There is no tax on any of the distributions if they are used for qualified post-secondary education expenses.
- The person making the contribution has control over the account.
- Depending on the state you live in, there may be some tax benefits from using certain 529 plans.
- The assets are allocated to the parent versus the child when applying for financial aid.
Let’s start with a little background on these relatively new plans. The 529 plan was created under the Internal Revenue Code 26 Section 529. While most plans allow investors to live out of the state under which the plan is administered, there can be advantages to using an in-state plan. There are two types of plans: prepaid plans and savings plans. Prepaid plans allow you to buy tuition credits in today’s dollars and use them in the future. Savings plans are more common and allow you to set aside assets very similar to a retirement account and have tax-free growth if the distributions are used for qualified expenses.
The investment options are similar to many 401(k)s, where “age-based” options seem to gain the majority of the assets. This is for a couple of reasons. First, a 529 is limited to a few investment changes a year, so putting the funds in an age-based model allows for the underlying assets to change while not counting against your statutory investment change limits. Agebased options allow for certain plans to use index funds, which tend to have lower costs than actively managed funds.
So what are the drawbacks? If you do not use it for a qualified education expense, you will pay tax on the earnings (not the contributions), plus a 10 percent penalty. This penalty can be avoided if scholarships are obtained by the beneficiary. As mentioned earlier, when tuition is paid from a 529, it may reduce needs-based funding sources. You may also reduce the eligibility of the American opportunity tax credit if certain dollars are paid out via 529 plan. Another detractor is that you may only have one beneficiary per plan. So, three children would require three plans.
One strategy that we see is a parent will fund the oldest child with the largest amount in his/her 529. If the funds are not fully used, they can change the beneficiary to the second or third child and use those assets for them. This is beneficial if one has been saving for years, then a child receives a scholarship, but another child or qualified family member, like a first cousin, does not.
In summary, just as with any investment, 529 plans are great avenues to save for college and the earlier you begin, the earlier you receive the benefit of compounding interest. Just as with retirement accounts, if you fund a 529 plan and want to receive the benefits of that plan, there are certain guidelines that you must follow. Using age-based funding is similar to retirement planning such that the sooner the funds are to be used, the less risky the investment allocation. The younger they are, the riskier the investment allocation. Pay close attention to the fees the plan is charging, the fees your adviser or broker/dealer is charging and the underlying investment performance of the plan. Also remember to start a plan as soon as that newborn has a social security number to receive the benefit of compounding.
This article is for informational purposes only and does not constitute tax, legal, insurance or investment advice. This article should not be considered a solicitation, offer or recommendation for the purchase or sale of any securities or other financial products. Travis S. Anderson