About 529 Plans
For most of us, sending our children to college will require a multi-faceted plan involving grants / scholarship, savings and loans. I have heard several colleagues lament that we earn too much for our children to get scholarships but too little to afford tuition. I’m here to say that that's simply not true --- about the scholarships. My oldest was offered scholarship money from a well-respected university and we had not even asked! Money is out there – ask for it! Scholarships come in all verities – from the normal money offered by universities (ask!) to the odd and down right strange. First rule – leave no money on the table – no matter where it comes from!
One thing to keep in mind about scholarship money is that if you use the money to pay tuition, fees required for enrollment, books, or supplies needed for courses, the money comes to you tax-free. If you use the money for room, board, travel or miscellaneous expenses then in most cases you will have to pay tax. So use scholarship money wisely.
When saving for children’s education, the 529 plan is the go-to instrument. 529 plans are tax privileged accounts named after section 529 of the IRS code (very original, right?). Although they are funded with after tax money (there is no federal tax deduction) they grow tax free and then, as long as the money is used for qualified educational expenses such as tuition, fees, books, room and board - no tax is paid when the money is withdrawn.
In 30 states and the District of Columbia, some or all of the contribution to a 529 is deductible from state income tax. In fact only 7 states that have state income taxes offer no deduction: California, Delaware, Hawaii, Kentucky, Maine, New Jersey, and North Carolina. Some states don't care which 529 plan you invest in (e.g.: Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana and Pennsylvania) while others require that you invest in their state plan to get the deduction. More information can be found here, be sure to check with you tax professional.
Plans are set up so that an adult is the account “owner” and the minor is “beneficiary.” Anyone can contribute to the 529 plan, including parents, grandparents and family friends. Only the owner controls the money in the plan, so if your child decides to not go to college, they do not have access to the funds. If the beneficiary decides to not go to college, or there are funds left over, the 529 can to transferred to another member of the family. If moneys in a 529 are used for non-qualified education expenses, you will pay federal income taxes and a 10% penalty on all the earnings. In some cases, if there are funds left over because the beneficiary gets a scholarship, the penalty for taking the cash may be waived.
There are limits on how much can be contributed to a 529. Contributions to a 529 are considered gifts. In 2018, an individual can give gifts totaling up to $15,000 before incurring a “gift tax.” What this means is that you and your significant other can each gift your child $15,000 per year ($30,000) with out incurring this tax. Thats is a lot! By definition, 529 plan balances cannot exceed the "expected cost" of the beneficiary's qualified higher education expenses – this is defined by individual states. Most states are quite generous with limits, some as high as $500,000!
There are two different types of 529 plans to consider: Prepaid 529 plans and College savings plans:
Prepaid 529 plans: with these plans essentially you are paying for tomorrow education in today’s dollars. For example, in 2018 a family “pays” for 8 credits tuition at a state university, these shares will always be worth 8 credits of tuition -- even 17 years later when their child is ready for college. There are 2 types of prepaid plans: contract and unit plans. With "contract" plans, you buy a certain number of semesters of college tuition based on todays cost. “Unit” plans let you buy fractional units (1 unit ~ 1% of a year's tuition) that are redeemable in the future. At one time almost ½ of the states offered prepaid plans; however as states budgets became strained many have decided these plans were too costly. Currently there are only 11 states left and more are looking like they are ready to jump ship.
There are drawbacks to the 529 pre-paid. If your child decides they don't want to go the school you chose, you may get back only your own investment plus inflation. Also if you ever move out of state you may be responsible for the difference between what you paid and current out-of-state tuition.
Recently, a number of private colleges and universities have banded together to offer 529 plans. More information is available here.
College savings plan: These are currently the most popular 529 plan. Plan specifics vary from state to state but essentially plan owners have the option of investing in a range of mutual funds. Most offer an age-based “auto-pilot” fund where large portion of the investment is in higher yield stocks when the beneficiary is young and as they approach college age the mix is adjusted to have a higher percentage of low risk investments such as bonds. For many, this “auto-pilot” fund offers a real convenience. Others will want to custom design an investment strategy.
The fund offerings vary quite a bit from state to state and you do not have to purchase the 529 plan offered in your state. So if you reside in Louisiana but the plan in Nevada is more attractive – you can invest in Nevada’s 529. You really need to shop for the best plan. Two important things to consider are state taxes and plan expenses. We have already looked at the effect of mutual fund expenses over time. You need to pay attention to plan expenses, they vary wildly from state to state. Also, in 30 states and the District of Columbia, some or all of the contribution to a 529 is deductible from state income tax; however in 23 of these you must invest in the state 529 plan to get this benefit. If you live in one of these 23 states, then the best plan may be the state plan. If you live in a state that offers no deduction, has no state income tax or doesn't care where you invest to get the deduction then you really need to shop around for the best plan. Often the best plan is the one with the lowest expenses. Personally, no matter what state I lived in, I would compare my state’s plan – including the effect of taxes - to one that offered low-expense funds (e.g. Vanguard). Clearly, you have some homework to do!
How much should you invest in a 529? How much can you afford? Because the time horizon is somewhat short (~18 years) we cannot rely on the effects of compounding to the same extent as retirement accounts where the time horizon was 40 years away. Let say for a moment you have a newborn (congratulations by the way) and in 18 years you would like to be able to pay for ½ of their tuition at your state institution. As we already saw, in 2037 total cost (tuition, room, board and fees) for one year at a 4-year state institution will average $53,000 (~$200,000 /4 years). So you are looking to have ~ 100,000 on-hand in 18 years. Assuming that your 529’s after expense return is ~5%, you will need to put away $286 a month (or $61,776 ) over 18 years. If you put away $143 a month you will have $50,000 to contribute to college expenses.
A few last words about 529s. First, don't forget that you may be able to deduct contributions from your state taxes. Depending on your state this can be a big deal - essentially the sate is helping pay for your child’s education. Also, when comparing different state 529’s be sure to consider the effect of both expenses and state tax deductions. Lastly, remember some one will lend your children money for college – no one will lend you money to retire. Funding retirement accounts should come first.