529 College Savings Plan – The Best Way to Save for College?

One of the best ways to save for college is with a 529 College Savings Plan.  Why should you care about a 529 plan? Because they can offer some very nice tax benefits as an incentive to save for college. Let’s take a look at 529 plans and why they are a great way to…
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One of the best ways to save for college is with a 529 College Savings Plan.  Why should you care about a 529 plan? Because they can offer some very nice tax benefits as an incentive to save for college. Let’s take a look at 529 plans and why they are a great way to save for college.

While college planning can cover a lot of different topics, this article will focus on:

  • Defining what a 529 plan is
  • Describing the two types of 529 plans
  • Pros and cons of each 529 plan
  • Outlining how a 529 plan can be used in conjunction with other military benefits

So, what are 529 plans?

Great question.  According to the Securities & Exchange Commission, a 529 plan is: “a tax-advantaged savings plan designed to encourage saving for future college costs.”  Section 529 of the Internal Revenue Code provides for this savings plan to:

  • Be sponsored at the state level
  • Provide tax-deferred growth and tax-free gains on qualified distributions
  • Allow for greater savings than previous plans, like Coverdell (formerly known as education IRAs)
  • Allow account holders to control funds in the event the beneficiary doesn’t go to college

In other words, a 529 plan is one of the ways that the government encourages investment in higher education.  The federal government doesn’t tax income for investments that are earmarked under the 529 plan.  Each state government sponsors an individual plan, which encourages people to invest and go to college in their state.

Regardless of which type of plan you choose, there are some things to point out:

  • You don’t have to be the parent of a beneficiary to establish or contribute to 529 plans. 529 plans allow for relatives, such as grandparents, aunts and uncles, or other members, to contribute.  This is great if you have a lot of family members who want to contribute or give presents but don’t know how.
  • You control the money, even if your child doesn’t go college. This level of control is unique to the 529 plan, and unlike the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA), both of which revert to the beneficiary’s control when they reach legal age.

Rich relatives can help, A Lot! But there may be some rules for family members contributing to 529 plans:

  • Contribution ceilings: First, most 529 plans have very high contribution ceilings.  For example, Texas allows you to contribute up to $370,000 per beneficiary.  Even after the ceiling is reached, most plans allow for earnings to accrue…you just can’t contribute any more to them.
  • Special gift tax rules: Most people are familiar with the annual exclusion for taxable gifts.  If not, here it is in a nutshell:  In 2016, you can give up to $14,000 to any person without having to file a gift tax return.  Any amount above that, and there are gift tax implications.  For 529 plans, there is a special rule that allows you to gift up to 5 year’s of contributions at once.  The donor will still have to file a gift tax return, but this is great if you have a rich uncle (or grandparent) who wants to help you supercharge your child’s savings.  I would advise anyone making such a large gift to seek the advice of a tax professional, but anyone who is in a position to do this is probably already working with one tax professional.

Types of 529 plans – Prepaid Tuition Plan and College Savings Plan

There are two types of 529 plans:  Prepaid Tuition Plans and College Savings Plans.  Let’s break down each one and look at the pros and cons.

529 Prepaid Tuition Plan

A prepaid tuition plan allows you to purchase credits from a state’s sponsored plan, which would then allow you to send your child to a public school from that state.  Depending on the plan, you lock in tuition at a certain price, then you make payments for a certain time.  This allows you to plan and execute a long term budget for the tuition plan.  Here are some of the pros and cons:

Prepaid Tuition Plan – Pros:

  • Tuition stability. As long as you continue paying into the plan, you’re guaranteed to lock in tuition at current or near-current rates.  This does offer peace of mind for people concerned about inflation and rising college tuition costs.
  • Investment risk. Since prepaid tuition plans purchase tomorrow’s tuition at today’s prices, you do not invest in the market.  Most state plans are guaranteed by the full faith and backing of the respective state, or that there is a state sponsored process to ensure that your plan keeps pace with tuition.  However, some plans offer no such guarantees, so you will want to make sure that the plan you’re paying into does.
  • Supplemental plans. In addition to prepaid tuition, some states offer supplemental plans.  Supplemental plans can include expenses such as room and board, meals, or administrative fees that seem to find their way into those college bills.

Prepaid Tuition Plan – Cons:

  • The biggest con is that tuition stability comes at the expense of flexibility.  You are essentially locking in tuition rates at a state university in your state where you bought the 529 plan. If your child chooses to go to a university out of state or a college that is not covered, you can pull your money out of the plan.  However, you’ll most likely find that the real rate of return (return after inflation) is very low.  For people who are not attached to their state of residence (like military families who PCS often), this lack of flexibility is very important to consider.
  • You might find that some plans do not actually protect against inflation, but force you into paying more at today’s prices than you might on your own.  For example, the Florida Prepaid Tuition plan came under fire several years ago for having prepaid tuition rates that ended up costing more than the projected tuition itself!  You’ll want to do your own due diligence before you start paying into the plan.
  • If, for some reason, you pull your money out of a plan, the plan will refund your contribution.  However, most plans will only give you your original contribution, with a reduced amount of interest.  You can also expect to pay a cancellation fee.

529 College Savings Plan

A college savings plan allows you to save money into a plan, which can then be used to pay qualified college expenses.  Unlike a prepaid tuition plan, a college savings plan can be used to pay for a variety of non-tuition expenses, such as books, fees, room and board, etc.  While you do not lock in tuition at a certain rate, a college savings plan offers flexibility and the opportunity to make investments that may maximize long-term value.  Let’s look at the pros and cons:

529 College Savings Plan – Pros:

  • Flexibility. As long as you continue paying into the plan, you’re guaranteed to lock in tuition at current or near-current rates.  This does offer peace of mind for people concerned about inflation.
  • Investment options. Most savings plans allow for a broad variety of investment options.  Many of these plans include target-date funds (similar to TSP’s Lifecycle Funds).  Target-date funds automatically rebalance towards more conservative investments as you get closer to withdrawing your money.  This generally reduces your risk as you get closer to needing to make withdrawals for tuition and related qualified education expenses.
  • Supplemental plans. In addition to prepaid tuition, some states offer supplemental plans.  Supplemental plans can include expenses such as room and board, meals, or administrative fees that seem to find their way into those college bills.

529 College Savings Plan – Cons:

  • Inflation risk. The benefit of a prepaid plan is the exact weakness of a savings plan.  While you are able to control your investments, you are responsible for ensuring that they are able to cover college costs.  If you underestimate college cost inflation, you might find that your savings plan isn’t enough to cover all the costs.
  • Investment risk. Having control over your investments means that you are ultimately responsible for investment risk.  While target-date funds help to mitigate this risk, there is no guarantee that a ‘black swan’ event, such as the Great Recession, won’t disrupt your planning.

To summarize, the relationship between prepaid tuition plans and college savings plans comes down to risk.  In this regard, this relationship is very similar to that between defined contribution and defined benefit retirement plans.  Your choice should reflect how comfortable you are with the relationship between risk, opportunity, and flexibility.

Using 529 Plan Savings

529 funds can only be used to pay for expenses related to college or other post-secondary training institutions, such as a vocational school. Withdrawals from your 529 College Savings Plan are exempt from federal taxes if made for qualified higher education expenses (QHEE). Qualified expenses include tuition, room, board, books, supplies, and required equipment.

529 plan funds cannot be used to repay student loans, student loan interest, travel, transportation, insurance, the cost of private housing in excess of the cost of student housing. There are specific rules regarding QHEE. Be sure to read up on them before making withdrawals.

Coordinating 529 Plans With Other Options

Many people consider 529 plans as an ‘all or none’ type solution. Having access to the Post-9/11 GI Bill opens a whole lot of options to ensure that you are comfortable with your college planning.  Below are a couple of ways to ensure that your 529 plan achieves the best benefit:

Talk to your kids early and often about college. The number one factor in making sure you can afford college is communication.  What do you talk about?  For starters, talk about setting reasonable expectations.  Discuss what resources you’re willing to set aside, and what they’re expected to contribute.  Be sure to emphasize that cost is a consideration.  Telling your child that you’re willing to pay for whatever they want to do will lead to an uninformed decision.

We don’t do it when buying their first car, so why should you do it just because you think education is important?  If your children know that cost is a factor, you might be surprised at how they approach college.  Also discuss the importance of responsibility.  If your children know that they are ultimately responsible for their education, they’ll take the responsibility of paying for it more seriously.  If they think their parents are paying the bills and taking care of everything, they might not.

Discuss the importance of high school success. While we all strive to maintain a balance as parents, our children should know that there are plenty of high school opportunities that can mitigate college costs.  Dual enrollment, AP courses, varsity sports, community involvement, and extracurricular activities can help your child eliminate easy courses or obtain scholarships that help mitigate your out-of-pocket costs.

Community college could help considerably. Most states allow for the transfer of community college credits to public state schools.  The opportunity to pay 30-50% less for the same course is a no-brainer.  Encourage your children to look into this opportunity.

Educate your children on the GI Bill. If you have more than one child, or you’ve already used some of your benefit, you might need to figure out how much you plan to give them.  Make sure they understand how GI Bill benefit should be used for the biggest bang for your buck.  A semester of community college is covered the same way as a semester of a master’s program, so you should save the GI Bill for the most expensive one.

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At the end of the day, you should choose the 529 plan that makes the most sense in your family’s situation.  Early in your parenthood, take the time to figure out how that plan makes sense for you.

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