If you don’t prepare for your financial future, you’ll end up in a jam. You might have already started saving money for your retirement. Paying for your child’s or children’s college education, should you choose to take on that burden, will require a major chunk of money that you should get going on saving sooner rather than later. Having a clear understanding of your options and their stipulations will serve you well in that endeavor.
What is a 529 plan?
A 529 plan is a tax-advantaged educational savings plan operated by an educational or state institution.
529 plans were created by Congress in 1996, and “529” stems from their required compliance with section 529 of the Internal Revenue Code. They are legally known as “qualified education programs.”
There are two types: the traditional and more well-known type, “college savings” or simply “traditional” 529 plans, and “prepaid tuition” 529 plans, each of which we’ll explore in detail in this article. However, contribution limits and their ramifications with respect to financial aid are shared by both types.
The 2017 maximum contribution one can make per beneficiary without incurring the gift tax (that is, the gift tax exclusion) is $14,000, and a special provision applying to 529 plans permits up to five years’ worth of contributions to be gifted in one front-end lump sum, for a total of $70,000.
A married couple can contribute double; up to 28,000, or if they opt for the five-year lump sum, $140,000.
Impact on Financial Aid
Expected family contribution (EFC) is a measure of how much a dependent student and their family can put toward their child’s post-secondary education and is a prime determinant of eligibility for financial aid, such as Pell Grants and work-study programs. Education savings accounts such as 529 plans are factored into its calculation, but relatively minimally. If a 529 plan is owned by the dependent student (as a custodial account, or one that a parent controls for a minor) or their custodial parent (including a stepparent if married to the biological custodial parent), it is reported as a parental asset of the parent on the Free Application for Federal Student Aid (FAFSA). Parental assets are assessed at a maximum rate of 5.64%. In other words, up to $56.40 of every $1,000 held in 529 plans may be included in the EFC. This is fortunate by comparison to alternatives; the federal aid formula counts between 22% and 47% of parental income in the EFC, and student assets are assessed at 20%. Further, if a parent has a 529 plan for more than one dependent child, they must report it as part of their net worth investments on the FAFSA, even if the others are not currently filling out a FAFSA.
If the plan is owned by anyone besides the student or their custodial parent, it is not reported as an asset. Instead, when the nonparent withdraws the funds to pay for the beneficiary’s college expenses, 50% of the amount is counted as student income on the FAFSA for two years hence (starting with the 2017-2018 school year), as Vanguard explains. Thus, if a grandparent withdraws $10,000 from their 529 plan account and provides it to a college freshman, $5,000 of it will count toward determining their available assets with regard to financial aid eligibility on their FAFSA submitted during their junior year.
College Savings Plans
College savings plans, also known as traditional 529 plans, work similar to IRAs or 401(k)s in that you (the “college saver” or “account holder”) will be investing your contributions within your pick of stock, bond, and/or money market mutual funds. College savings plan accounts are subject to market risk; they may not generate any profit or even decline in value.
529 college savings plan portfolios can be static or age-based.
Like a target-date fund, age-based portfolios automatically shift toward more conservative investments as the beneficiary’s window of time before college age narrows.
Static portfolios, on the other hand, have a fixed asset allocation and allow you to choose where each of your portfolio’s investments lie on the conservative-aggressive spectrum based on your risk tolerance.
Distributions from college savings plans can be put toward tuition and mandatory fees, room and board, and even required books, computers, and software.
529 college savings plans are lauded for their tax benefits, which are similar to those of Roth IRAs. Earnings (capital gains and dividends) on contributions compound and can be withdrawn federal-tax free so long as they are used for qualified educational expenses. That said, federal contributions are not tax deductible.
If not used for qualified educational expenses, college savings plan earnings are subject to regular income tax plus a 10% federal tax penalty (as you may recall is often the case for retirement accounts as well).
States follow the federal treatment of 529 college savings plan taxation, and some also allow a state income tax deduction and even matching contributions as incentives for their residents to choose their home state’s 529 plan, given that state residency is not a limiting factor in 529 plan choice.
In fact, over 30 states and the District of Columbia offer a full or partial income tax deduction on 529 plan contributions. Among those remaining are the seven states that simply do not charge a state income tax: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming; and nine states that don’t offer a deduction: California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, North Carolina, and Tennessee.
Additionally, some states have a loophole that allows a current college year’s costs to be contributed to a college savings 529 plan and withdrawn as soon as a day later, making the account holder eligible for an income tax deduction so long as the funds are used for qualified education expenses. This is due to their lack of a waiting period on withdrawal of funds, which some states set to one year.
In choosing where to open your 529 plan, weigh the potential savings from state income tax-deductible 529 plans and any other perks that may be offered against the potential after-fee returns of out-of-state 529 plans; it could be that out-of-state 529 plans are still a better option due to lower fees. That is typically the case for longer investment horizons, but if the beneficiary will be enrolling soon, the deduction likely trumps the lower fees due to the shorter amortization period.
A word of caution: If the amount of 529 plan savings distributed is greater than the beneficiary’s qualified education expenses, taxes may be owed on the difference.
Who Can Open a 529 College Savings Plan
Anyone 18 years of age or older who holds U.S. citizenship or resident alien status may open a 529 college savings plan for another person or even for themselves. A beneficiary may also have multiple accounts opened in their name by different individuals.
There are no age limits; both adults and children may use a college savings plan.
College savings plans are available in all states as well as the District of Columbia, and you aren’t limited in choice to those in your own state.
College savings plan enrollment is open year-round. However, investment options may only be chosen once per year.
College savings plans do not have state backing or guaranteed results; investment results are subject to market risk.
You may rollover money from one 529 plan to another or change beneficiaries within a 60-day time frame. However, beneficiaries’ accounts can only be rolled over once per year.
Prepaid Tuition Plans
Prepaid tuition plans’ main benefit is that they allow you to lock in current tuition prices.
If opt for this type, you would pay a portion of tuition expenses associated with state public or private college education in advance at a predetermined contract price based upon factors such as the grade of the beneficiary, current and projected tuition costs, and the expected rate of return. The funds are transferred directly to the beneficiary’s educational institution upon their enrollment.
Investment options are not applicable in the case of prepaid tuition plans since the onus is on the state to invest your money. They may be be more attractive to risk-averse individuals afraid of losing their contributions in the stock market, although not all states fully guarantee fulfilling their end of the deal if they fall upon hard financial times.
The costs of post-secondary education have been on the rise, making this plan type a compelling option. After adjusting for inflation, between 2011 and 2016 tuition rates rose by 9% at public four-year colleges, by 11% at public two-year colleges, and by 13% at private four-year colleges, per the College Board.
Where Are Prepaid 529 Plans Available?
While 529 college savings plans are available in all states and the District of Columbia, prepaid tuition plans (or prepaid 529 plans) are only available to those in 11 states: Florida, Illinois, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia, and Washington.
Perhaps their biggest drawback is that they can usually only be used for public, in-state colleges.
The most common form of prepaid tuition plans is a contract plan, in which you exchange a lump sum or series of installment payments for the obligation of the state offering the plan to pay a predetermined amount of college expenses (such as a number of semesters or years of college). They are similar in function to futures contracts, which give investors the option to purchase assets at a preset price at some point in the future.
Less common are unit plans, in which you’d purchase fractional units or credits that are representative of a percentage of average yearly tuition at the plan’s participating colleges. The value of these units fluctuates from year to year.
There are also voucher plans, which provide a discount of a specified portion of tuition.
Contracts come in an array of varieties that vary between state plans, covering between one and five years of tuition, and some offer the option of being put toward a combination of community and four-year college, just one or the other, and sometimes graduate school as well.
Prepaid tuition plans typically only cover tuition and mandatory fees at in-state public colleges; they are more limited in scope than college savings plans. Some plans allow you to purchase a room and board option. Unlike college savings plans, tuition prices are locked in.
Most prepaid tuition plans have age/grade restrictions.
Most prepaid tuition plans stipulate that you or the plan’s beneficiary must be a resident of the state in which they are offered at the time of application.
Most prepaid tuition plans have a limited enrollment period. For instance, Washington State’s Guaranteed Education Tuition (GET) program has a November 1st–May 31st enrollment window.
Are There Guarantees?
Prepaid plans, unlike college savings plans, are typically sponsored by the state in which they are held and offer some sort of guarantee.
Just four of the 11 states with open prepaid plans are fully backed by the state: Florida, Massachusetts, Mississippi and Washington, while that of Texas is backed by its state public colleges.
Are Private Schools Eligible?
Nearly 300 private colleges offer the Private College 529 Plan, formerly known as the Independent 529 Plan.
What If Plans Change?
Prepaid 529 plans can typically be transferred to a younger sibling of the original beneficiary. If the beneficiary doesn’t want to use it and transferring it is not feasible, or if you would like to cancel it, you will likely receive back your contributions but not gains. There may be a cancellation fee.
You aren’t limited to just one type of 529 plan. It may be wise to consider purchasing a prepaid tuition 529 plan for the tuition portion and a college savings plan for the additional college expenses not covered by the prepaid plan (which often include room and board, books, and fees). In either case, do your homework before making this important decision. There is a glut of outdated information on the topic across the web; be sure to consult direct and current sources.
Lastly, a 529 plan isn’t your only option for college savings, and it might not be your best. Some alternatives to consider include a Roth IRA and a Coverdell Education Savings Account (ESA).
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