Preparing for Higher Education: 529 College Savings Plan
Suzanne was accepted to the prestigious four-year college of her choice, and her academic prowess landed her a 50 percent tuition and room-and-board scholarship. Her parents were ecstatic; the scholarship in itself was a major accomplishment, but with it they knew Suzanne’s college experience, and quite possible her grad school costs, would be fully funded.
That’s because both Suzanne’s parents and grandparents had done their due diligence; they had investigated and invested in 529 college savings plans, named for the section of the tax code that created them.
Incentives for Saving
Congress created these plans, legally named “qualified tuition programs,” in 1996, and all 50 states have established them. There are two basic types, prepaid tuition plans and savings plans; each state’s program is somewhat unique.
Any U.S. citizen or resident alien 18 years of age or older can open a 529 account. The individual who purchases the plan is the custodian, and she designates one beneficiary per plan, usually the student who will benefit from it. The custodian makes contributions, which are not tax deductible for federal tax purposes (although some states allow a deduction), but all earnings accumulate tax free and withdrawals are also tax free when used for qualified educational expenses at any qualified college or university in any state. The custodian may contribute up to five years of the allowable annual gift tax exclusion, currently $14,000; she retains control of the account and may change the beneficiary or roll the funds into another plan without penalty. There are no income limits for either the custodian or the beneficiary. The IRS states that “contributions cannot exceed the amount needed to provide for the qualified education expenses of the beneficiary,” yet the rising costs of college and post-grad education make this a nebulous statement.
A state’s prepaid tuition plan differs from a 529 plan in that it typically requires the custodian or student to be a resident of the state. It allows a parent to purchase future tuition at today’s rates, and most states guarantee that the funds in a prepaid plan will keep up with rising tuition costs. The student is restricted to qualified institutions within the state, and frequently the withdrawals are limited to payment of tuition and fees, not room and board or other expenses.
A student can have multiple accounts set up for her; a parent or grandparent can also set up more than one account, and can even set one up for their own educational expenses. And the custodian is not restricted to plan investments in their state of residence. It can pay big dividends to investigate earnings and costs of plans in other states, as it’s a competitive market.
Withdrawals from a 529 plan are not counted as income in financial aid formulas, so this money has a smaller impact on the financial aid for which the student is eligible. Assets inside the plan are assessed at 5.64 percent of their value, whereas other assets owned by the student are assessed at 20 percent in the formulas.
When and How to Use the Earnings
The maximum tax-free withdrawal for most parents and students will be 100 percent of the beneficiary’s qualified higher education expenses in the year of the withdrawal–tuition, room and board, fees, books, supplies, computer equipment–minus $4,000, which is directed toward the American Opportunity Tax Credit. Based on its formula, this credit is worth up to $2,500 in federal tax savings. The $4,000 adjustment must be made to prevent creating a non-qualified distribution from the plan.
Take the withdrawal in the calendar year in which the qualified expenses are incurred, at any point during the year, but review the expense versus withdrawal numbers to make sure the withdrawal for each year is maximized. Also, it’s advisable to verify your individual situation with your tax professional to minimize any penalties you might incur with timing and withdrawal amounts.
The first step is to learn about the 529 plans offered in your state of residence, to maximize any available state tax deduction, through the directory of plans at savingforcollege.com. This website tracks costs and performance of more than 100 plans available in all states, plus other information such as asset allocation.
Opening an account can be accomplished online, with regular deductions made from your checking or savings, like payroll deductions, or you might be more comfortable working with your personal financial advisor. Remember that you are making investment choices, and these should be compatible with your own comfort level with risk. Most 529 savings plans are invested in large, widely held mutual funds managed by established companies such as TIAA-CREF, BlackRock, Vanguard and many others.
An investment in education is one of the most important steps we can take. Why burden yourself or your child with student loan debt? Avoid it by starting your 529 plan today. HLM
Sources: collegesavings.org, finra.org, irs.gov, money.usnews.com, savingforcollege.com and wsj.com.