Many Baby Boomers and Gen Xers remember working a part-time job and graduating college with little or no debt. Unfortunately, that memory is no longer a reality for most college students today, since the cost of a 4-year public university has more than doubled since 1989, +2.5% per year even after inflation! Conversely, wages grew only an average of 0.3% per year (according to Forbes).
Roughly 70% of American students take out loans to go to college, graduating with more than an average of $30,000 in unsecured debt – but since we’re all about planning, what can we do to prepare for our own children’s education costs?
What is a 529 Plan?
A 529 plan is an education savings vehicle that offers tax-deferred growth and tax-free distributions if the funds are used to pay for qualified education expenses. These funds can pay for qualified expenses at community colleges, public & private colleges, universities, vocational schools, graduate schools, and some foreign institutions. See the Federal School Code for the full list of federally approved schools.
Contributions to these accounts can always be withdrawn without penalty (similar to a Roth IRA), but earnings are subject to income tax and a 10% penalty if not used for qualified education expenses.
Which expenses are “qualified” for tax and penalty-free distributions?
- Tuition (including up to $10,000/yr for secondary schools K-12)
- Room & Board (enrolled at least 1/2 time)
- Computers & Software
Any adult can open a 529 account, with any person (with a valid Social Security number) as the named beneficiary (the student), and a successor owner listed for contingent ownership. If the parent of the student is the account owner, the funds are considered ‘parental assets’ for financial aid (FAFSA) considerations. This is favorable, as assets owned by the parents (5.64% considered) are not counted as heavily for the Expected Family Contribution (EFC) calculation as assets owned by the child (20%). It is most common for parents or grandparents to own this account, with a caveat that distributions will count as student income (50%) if the 529 account is owned by a non-parent during college – transfers of account ownership may be strategically timed.
Contributions to a 529 account must be made with cash and can be set up with automatic (recurring) or one-time payments, online or by check. Anybody can contribute, but only the account owner can choose the investments, take withdrawals, or change the beneficiary. The beneficiary can only be changed to family members of the previous beneficiary (child, descendant, sibling, parent, cousin, aunt, uncle). Contributions may or may not provide a state income tax benefit; check your state’s plan for details – if your state’s benefit isn’t substantial, shop around nationally to find the best plan for you.
Investment options with the 529 account vary by provider, but usually include target date funds, static portfolios, or individual mutual funds. Target date funds simplify investing, because the mix of equity (stocks) and fixed income (bonds) is adjusted over time to gradually become more conservative/less risky by the time the money is needed. Static portfolios are managed and based on risk tolerance (preservation, balanced, or growth), but do not adjust over time. Individual mutual funds can be chosen, but do not involve any professional management – these may be cheaper than the other options, but are not automatically rebalanced. Investment allocation strategies in a 529 account may only be changed twice per calendar year.
Distributions from a 529 account can be taken online, over the phone, or by mailing a distribution request to your account custodian. The funds can be sent directly to the educational institution or to a linked bank account. All of the account assets must be distributed within 30 years after the beneficiary graduates from high school.
But what if my child doesn’t go to college or need it all?
As previously mentioned, distributions of earnings taken for non-education expenses are subject to income tax and a 10% penalty, but thankfully there are other options to consider.
- If the beneficiary receives a scholarship, the amount equal to the scholarship may be withdrawn without penalty, with only taxes owed on the earnings.
- The owner may designate a new beneficiary, including a family member or child of the original beneficiary.
- If the beneficiary dies or is disabled, the taxes and penalty are not incurred.
Now that we understand the value of 529 college savings accounts, we can create a payment plan and watch compound interest do its job. Decide how much education you’d like to fund, estimate the future costs, then calculate the payments or lump sum required to reach your funding goal. It can actually be helpful not to fully fund this account, because of education tax credits and future unknowns. A financial planner can help you calculate the financial need and consider alternatives.
Before building up education savings for your child(ren), make sure that your own retirement savings are already in alignment with your future needs. Relate this thinking to how flight attendants instruct you to put on your own oxygen mask before assisting others. You can take out a loan for college, but you can’t take out a loan for retirement!