For parents of college bound kids, the month of October is usually centered around getting the FAFSA application completed and submitted with the slim hopes that for some reason the Federal government or the school their child will be attending might grace them with the gift of grants or low interest student loans.
We have all heard the stories of the eye-popping costs to send the average child to college. Having just launched a set of twins off to their freshman year at college, I can now tell you from experience - those stories are true! Some families get lucky if their child is exceptionally bright or athletic and are offered scholarships. Unfortunately, that is not the case for the vast majority of our college-bound kids.
As is the case for anything important in our lives, the best thing we can do for ourselves and our children is to start planning for this life event. Of course, the earlier the better, but it really is never too late to start. Even if you are only a few years from graduation day you can still give yourself a head start.
In 1996 the government established the 529 Plan account to help parents save for college. The 529 Plan is an education savings account that is designed to encourage families to save for college by offering tax benefits for the contributions and earnings to the account. 529 Plans are operated by a state and/or a financial institution. While most states have their own plans, anyone is free to open an account with any of the plans in place. There are some tax benefits that we will discuss if you open an account run by your own state of residence. It is also not a requirement that the beneficiary (child) be a resident of that state or attend a college in that state.
There are a couple of types of 529 Plan accounts:
● Savings Plans - this type of account allows you to save as little or as much money as you would like to put away (there are maximums that vary by state, but they are typically over $300,000 in lifetime contributions). There are different investment options that either you or your financial advisor can choose from. The account value will move up and down based on the market performance of the investment options that you selected.
● Prepaid Plans - this type of plan will allow you to pre-pay all or part of the costs of an in-state public university tuition. The funds can be converted to pay for use at a private or out-of-state college. With this type of account you are not making investment decisions. Why would someone want to put their child’s college funds into a 529 account instead of just a regular investment account? First and foremost, the biggest benefit of a 529 account is the tax benefits that the account owner enjoys throughout the life of the account. There are two types of tax benefits:
● Contributions to an in-state 529 Plan - if you open an account that is operated by your state of residence, many states (Illinois is one of them) will allow you to deduct contributions from your state taxes up to $10,000 per person ($20,000 for a married couple) per year.
● Tax-free earnings for the account - this is where the real tax benefit comes in. As long as the assets are used for qualified education expenses (we will discuss what is considered a qualified expense later), the funds can be withdrawn tax-free.
o Let’s do a simplistic example to show how much that could mean in savings. If you decide to start investing a $1,000 a year from the year your child is born until they go off to college, you would have contributed $18,000 to their college funds. If we assume the account grows by an average of 5% over the 18 years, the account would grow to approximately $28,000 by the time they are ready to go off to college. So we have about a $10,000 earnings gain. If those funds were put into a 529 account, the $28,000 could be withdrawn to pay for college, tax-free. If those funds had instead been invested in a regular investment account, when we went to withdraw those funds there would taxes due on that $10,000 in earnings. Even if we used the lowest tax rate of 15%, the taxes owed when making the withdrawal would be about $1,500. Again, this is a simplistic example for illustrative purposes only.
As you can see, the tax benefits can really add up over time.
The other benefit worth noting is that in an attempt to encourage parents to put money away for college, when the time comes to fill out FAFSA (financial aid forms), 529 accounts are treated much more favorably than a regular investment account. So when FAFSA calculates how much in assets a family has available to pay for college, they count 5.64% of the value of a 529 account versus a regular investment account where they will count 20% of the value.
Now let’s consider some of the potential issues that parents should think about before opening one.
● Let’s start with the most important one- fees. Whether you are working with a financial advisor or setting the account up on your own, make sure you understand what fees you are paying. Ideally, if you are working with an advisor they are charging you a discounted fee for investing in a 529 account. You will also want to make sure you are getting invested in the investment options that have the lowest underlying expenses. There can be a very wide range of fees that are charged to different investment options in a 529 Plan. Make sure you ask your financial advisor these questions.
● Given the tax advantages of a 529 account, many parents worry about what they would do with the account if there is a financial emergency and the family needs to access these funds for something other than their child’s education, or if their child gets a scholarship or may decide not to go to college at all. Let’s address each of these issues:
o If the account owner needs to access the funds in the 529 account for something other than qualified education expenses they will be required to pay income taxes, plus a 10% penalty on the earnings portion of the withdrawal. This is an important point to note because often times people think they will pay taxes and penalties on the entire withdrawal amount. It is only on the earnings portion that has accrued. But, no, you cannot choose to just withdraw the contribution portion of the account; the withdrawal will be a pro-rata share of the contribution portion and earnings portion of the account.
o If a child gets a scholarship or some other form of financial aid, the account owner can show proof of this aid and are then allowed to withdraw funds from the 529 account in the amount of the aid and will only have to pay income taxes on the earnings portion, but not the 10% penalty.
● 529 accounts will only cover qualified expenses. Expenses that are not considered qualified will have to be paid for with other assets. Qualified expenses include: tuition, room and board, books, and computer requirements. If the student lives off campus, then an average dorm rate at the college will be used to calculate an acceptable amount that can be withdrawn from the 529 account to be used for rent. Non-qualified expenses would be transportation to and from school, extra-curricular activities like club sports, or fraternity and sorority membership costs.
If you are a grandparent or other relative who is considering contributing to a child’s 529 account, you may want to open up your own account with the child as the beneficiary. When the time comes to apply for financial aid, non-parental accounts do not get included in the asset calculation to determine financial aid. Once these funds are used to pay for college, the amount used will be included in the income calculation to the child. Advisors typically recommend that these funds be used in the last year of college after all financial aid applications have been submitted.
When it comes to planning for college, my advice is to start as early as possible. Even if you can only contribute $50 per month to start, the benefit of time is in your favor. Take advantage of that. As a parent you will feel better knowing that you have started taking an active role in planning for your child’s future. It might make it a little easier to say ‘no’ to that toy that they don’t really need when you know that those funds are instead going towards their college education. Even if you know you are unlikely to fully fund your child’s college account by the time they are ready to go (which most people are unable to), I can say from experience that it feels a lot better to be able to explore your child’s options with them, without being hyper-focused on what the cost is for each school they are considering. It is an overwhelming and exciting time for your child as they enter this whole new chapter in their life. It is a gift to parents to be able to experience it with them and guide them through it. When you can plan for this life event in advance, even if it only gets them part of the way, it allows everyone to enjoy the process that much more.