Most parents, even soon to be parents, have probably heard of a 529 plan. Perhaps college costs for your children are right around the corner, or perhaps they seem light years away. No matter where you are in that spectrum it is never too late to start a 529 plan. We’ve all heard the saying, “Every penny counts”, right?
What is a 529 Plan?
A 529 is a savings plan to help families fund the cost of college. They are typically run by a state or educational institution and offer a variety of tax advantages. 529 plans can be used at public or private universities as well as trade or vocational schools. 529 plans can be opened by anyone. It does not have to be opened solely by the parent of a child. Grandparents, aunts and uncles are all able to start a 529 plan for an eligible beneficiary. Unlike, ROTH IRAs and Coverdell accounts, 529 plans do not have income limitations which tend to make them extremely popular with those looking to save for college. But be careful, not all 529 plans are alike and you will want to do your due diligence before you select one. For example, there are two types of 529 plans. A prepaid tuition plan and a savings plan.
Prepaid Tuition Plans vs. Savings Plans
Prepaid Tuition Plans
A prepaid tuition 529 plan helps parents (or grandparents, etc) lock in the cost of college tuition now, at today’s prices, at eligible educational institutions. You can pay for the specified tuition (does not include room and board) in a lump sum payment or installment payments over the course of several years. There are many different options here and all the costs differ. Sounds great right? Make sure when researching prepaid tuition plans that you check the guarantees behind the plan. Some states will offer guarantees that should the plan run into financial hardship that the full faith and credit of the state will step in and make sure the funding is still available, other state plans offer no such guarantees. Currently only a handful of states offer prepaid tuition plans and typically you must be a resident of that state to participate.
In contrast, a 529 savings plan allows you to invest your money inside of a plan in investment accounts. Typically the money you invest is put into a portfolio of mutual funds. All 529 plans differ with investment choices so make sure to research carefully or talk to your financial advisor. The return on your investment in a savings plan is not guaranteed and will fluctuate with the market.
In both a prepaid tuition plan and a savings plan you contribute after tax money (contributions are not deductible on your federal return) and that money will grow tax deferred. All earnings are tax free as long as you use the money for qualified education expenses at the distribution phase. Additionally, 34 states including the District of Columbia, offer state tax breaks or incentives on your tax return for contributions made to the plan, usually, in the form of a deduction or a credit. In Pennsylvania for example, they will offer a state tax deduction up to $14,000 for a single filer and $28,000 for a joint filer on the state tax return.
Gifting into these programs has also become popular in recent years. A single filer can gift up to $70,000 into a 529 plan per beneficiary in one year without having to pay the gift tax. The gift is treated as if it was given over a 5 year period. Grandma and Grandpa could essentially gift up to $140,000 per beneficiary in one year without having to pay any gift tax. This strategy has become very popular in conjunction with estate planning.
Qualified Education Expenses
So what are qualified expenses? Typically, they are just what you would expect: tuition, room and board, textbooks and most recently computers and computer related equipment. Again, you will want to talk with your advisor prior to taking distributions to make sure that your distribution will not run amok of the rules and cause unintended tax ramifications. If your distribution is not used for an approved qualified education expense the IRS will assess a 10% penalty tax on the gains portion of that distribution.
What If My Child Does Not Go To College?
One of the many great things about 529 plans is their flexibility. If you have spent years saving for your child to go to college and they in turn decide that a four year college may not be the best choice for them you still have options. 529 plans can be used for most types of post-secondary education. They can be used at vocational schools, trade schools, and 2 year associate-degree programs. If this is still not an option for your child, 529 plans allow you to transfer the account tax free to another beneficiary as long as that beneficiary is a family member. You can even make yourself the beneficiary if you choose to go back to school. Typically, 529 plans allow you to change the beneficiary once per year if needed.
You do have the option to convert the 529 to a ROTH IRA for your retirement, however, you would be taxed on the earnings and may have to pay the 10% penalty tax since the monies are not being used for qualified education expenses. The one exception where the 10% penalty tax is waived is if your child gets a full scholarship or attends a U.S. military academy.
In the end, if you aren’t sure where or how to start don’t be afraid to start small. Remember, every dollar saved is helpful. Perhaps your 529 won’t cover the entire cost of college when it is time, but it is step in the right direction.
One bit of advice from a financial advisor, don’t forget to save for your retirement as well. One of our favorite sayings around here is “You can always take loans out for college, but no one will loan you money for your retirement.”