529 College Savings Plan
529 College Savings Plan

Putting together a college savings plan can be daunting. The rapidly rising cost of higher education can be intimidating, but don’t let the numbers scare you off.

According to the College Board, the average per year cost of a private four-year college is $39,400 compared to $10,950 for a state school.

If college expenses continue to rise at a higher rate than overall inflation, the cost will be much more 10 to 15 years down the road. These amounts leave many wondering if they’ll ever be able to save enough.

With careful planning and discipline, you have a much greater chance of making it happen.

529 College Savings Plan Basics

These plans are tax-advantaged investment accounts to promote saving for college. At least that’s what they were originally intended for. Recent legislation expanded their use for K-12 education and other educational programs. Simply put, they’re not just for college anymore.

These accounts don’t need to be for your own children. While that may be the most common scenario, you can set them up for almost anyone. The beneficiary needs to be a U.S. citizen or resident alien.

Tax advantages of 529 plans

These accounts have special tax benefits, similar to Roth IRAs. Money you sock away allow for tax deferred growth and tax-free withdrawals for qualified education expenses. In ordinary investment accounts, earnings like dividends and realized capital gains are subject to taxes.

Taxes chip away at your investment returns. Saving for future educational expenses with this special tax benefit allows more money to stay in your pocket.

There is no federal income tax deduction for contributions to a 529 plan. Don’t let that scare you off. This is similar to how tax-free Roth IRAs work.

State income taxes are a different story. State income tax deductions or credits are offered by most states. But there’s a catch. You must contribute to your state’s 529 plan. A small number of states will allow state income tax deductions if residents contribute to other states’ plans.

It can be easy to go down this rabbit hole but don’t let it distract you. 529 benefits for federal taxes is reason enough to give them a look. Consider the state tax benefits the icing on the cake.

How to open and contribute to a 529 plan:

Once you’ve chosen the investment provider, opening a 529 plan investment account is easy. Most investment firms allow you to open an account online and establish a link to your checking or savings account.

You can start saving for college with as little as $25 per month. Obviously, that isn’t going to cover all of the education expenses down the road. However, a little bit over a long period of time adds up to a lot!

How to invest in a 529 college savings plan:

As the account owner, you are responsible for matching your investment objectives with an appropriate mix of investments. This is most often accomplished with investments in mutual funds.

How you allocate the investments of the portfolio between high and low risk mutual funds depends on a few things. First, how many years until the funds are needed? Are you setting the account up for a newborn or a freshman in high school? Second, what is your comfort level with risk.

In general, the closer you are to needing to pay for qualified education expenses, the less risk you should take with the mutual funds.

If you’re going to be investing funds for the short term like 1 to 3 years, you should steer clear of the stock market and stick with CDs despite the low rates.

If you are investing with a longer-term time horizon, it would be completely prudent to allocate a portion of your investments to stocks. While CDs and a savings account are very low risk, they may not be the best bet for returns over the long term.

If you’re not comfortable making those investment decisions, the investment manager wil automatically adjust the portfolio to become more conservative as the beneficiary nears college age.

How much does a 529 plan cost?

Not all 529 plans are created equal when it comes to fees. Some are low cost and others, not so much. You need to look at annual charges and the expense ratio of the funds. This is expressed as a percentage. Anything with an expense ratio over 1.00% is suspect.

The good news is that competition in this space is fierce. This has led to reduced fees and costs for consumers. As a Certified Financial Planner™ and fiduciary advisor, I prefer low-cost investments. Whatever you save in fees will stay right in your pocket.

Qualified Educational Expenses
Qualified Educational Expenses

What are qualified educational expenses?

What you can spend 529 plan money on is broad. In general qualified educational expenses included tuition, room and board, technology, special needs resources, and school supplies.

What if I don’t spend the money on college?

You don’t have to spend the money on college, but the expenses do need to be qualified educational expenses.

In general, if you use funds within a 529 plan for anything other than qualified educational expenses, there will be taxes and penalties on the portion that is considered a gain.

For example, if you have $10,000 left in an account and $8,000 represents your investment (or principal), you would be taxed and penalized on the $2,000.

That $2,000 will be subject to federal income tax, a 10% penalty, and potentially state income tax. Total financial hit can be as high as $730 or more.

It’s important to note, the tax rate used to assess the penalty is that of the beneficiary. Most often, the beneficiary will be at a lower tax rate than the parent.

Are there exceptions to the 529 plan withdrawal penalty?

There are several exceptions when it comes to penalties for 529 plans. However, you still pay federal income tax. They include scholarship, military service, disability, and death.

Important tax changes coming in 2024

Beginning in 2024, unused balances in a 529 plan can be rolled over to a Roth IRA. This is a significant change that will allow people to avoid costly penalties.

However, there are restrictions:

  1. Rollover would transfer to the beneficiary’s Roth IRA, not the parent or account owner.
  2. You can’t rollover contributions or the earnings from the last five years.
  3. Rollovers are limited to the annual contribution limit ($6,500 in 2023)
  4. The 529 needs to have been in existence for 15 years.
  5. $35,000 cap for Roth IRA rollovers

The beneficiary can be changed

There is often concern about what to do with the funds if your child doesn’t go to college or use the funds for other qualified education expenses.

Beneficiaries can easily be changed. If you spend the 529 funds on the new beneficiary’s education expenses, you will avoid the taxes and penalties.

If the 529 plan is not a UTMA, you can change who will be the recipient of the funds. Some 529 plans have been funded via UTMA accounts. This is where funds have been gifted to a minor for their benefit.

At the age of trust termination, the minor takes control of the funds. If the 529 plan was funded with a UTMA account, you cannot change the beneficiary.

If you’re not currently saving, start.

Don’t wait to have everything figured out before to start. You can work out the details and fine tune as you go. Don’t let analysis lead to paralysis.

If you’re currently at zero dollars per month, start with $25. You don’t need to be an expert and sort through all the different types of account before you start.

529 College Savings Plan – Conclusion

College costs are steep. It’s not just the cost of tuition but room and board as well. If you’re already saving, look for ways to make a small increase.

The failure to start saving or even delaying it by a couple of years can make a huge difference. Once you start the 529 plan, you’ll be amazed at where you can find some extra dollars here and there.

Rome wasn’t built in a day and neither will your college fund. Over time, it will grow. Will the funds be needed in 5, 10, or 20 years? The answers to those questions will be your guide. A 529 plan will help get you there.

Do you have questions about setting up a 529 college savings plan?

Contact me today for your FREE consultation!

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