As parents, we all know college is going to be one of the most expensive costs that our children will face, and for most of us the expense is daunting. On the one hand, coming up with four years of tuition (more if graduate school is involved) would stretch our budgets to the extreme, if it is even feasible at all. On the other hand, we cannot avoid headlines about what student loan debt is doing to our children’s futures. Putting the burden fully on the child may create debt loads that could stay with them for decades, and impact career and life choices down the road.
With some foresight and an ability to save early and often, a 529 plan could significantly reduce the burden on the family when college comes around.
What is a 529 Plan?
According to the SEC website, a 529 plan is a “tax-advantaged savings plan designed to encourage saving for future college costs.” 529 plans “are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.”
Basically, a 529 plan is a type of investment account, which can primarily be used for college expenses. As families save in a 529 plan, the money is invested. The initial investment amount and all subsequent earnings can be used for qualified college expenses (e.g., books, tuition, room and board, etc.) without paying any taxes.
Why Should I Save in a 529 Plan?
Let’s look at an example. Assume that a college will cost about $60,000 per year for four years, or $240,000 total. That is a lot of money to come up with out-of-pocket as parents. It’s also a very large amount of student loans to take out and attempt to repay. In fact, just looking at that number makes college feel cost-prohibitive.
With some advance planning and saving, however, this cost can be mitigated greatly. For example, when a baby is born, he or she has about 18 years before college starts. Assuming a portfolio can average an eight percent return, if the parents can come up with $54,000 at or around birth, it would grow to more than $240,000 for college. Effectively, the family has cut the cost of college by more than 75 percent with planning.
However, there is a catch. If the family simply opens a normal (not 529) investment account, all the growth is taxable. So in the example above, the portfolio grew by $186,000 ($240,000 ending value - $54,000 beginning value). With a 15 percent federal capital gains rate in most cases, this means the family will owe $27,900 in taxes, reducing what can be used for college from $240,000 to $212,100. This is not ideal, but here is where a 529 comes in to play.
Had the family saved initially to a 529, the money would have grown tax-free and could be used tax-free (if the proceeds are used for “qualified higher education expenses” as discussed above). By using the 529 to pay for college, the family saves $27,900 in federal taxes (possibly more with state taxes) and reaches their funding goals more easily.
How Do I Get Started with a 529 Plan?
One major caveat with 529 plans: Because of the limits on how much can be given in a single year and the tax deductions that are often involved, it is strongly recommended you talk to your accountant and/or financial advisor when using these plans.
The biggest decision is choosing which states’ 529 plan to use. There is a different 529 plan, and sometimes multiple, in each state. Technically, a child can live in Florida, use a 529 plan from Utah, and go to college in Massachusetts. In fact, there are hundreds of colleges that are 529 eligible outside of the United States. (Here is a link to a handy resource for 529-eligible institutions around the world.) There is incredible flexibility on which plan and which college a family can choose.
The majority of states (assuming they have a state income tax) provide savers a state tax deduction for saving in a 529 plan. Some states only provide the deduction if you use the in-state plan, so for families in those states, it almost always makes sense to evaluate the in-state plan.
There are seven states (Arizona, Arkansas, Kansas, Minnesota, Missouri, Montana, Pennsylvania) that will give families the state tax deduction no matter which 529 plan is used. There are another seven (California, Delaware, Hawaii, Kentucky, Maine, New Jersey, North Carolina) that have a state income tax, but provide no deduction, so any plan can be chosen. And finally, there are another seven (Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming) that have no income tax.
The author’s general preference in cases where the in-state plan doesn’t provide the greatest benefit is the Utah's My529 plan, but there are a number of other good, low-cost options available (e.g., New York's NYSaves plan and Illinois’ Bright Start to name a couple of others). If a family isn’t tied to their in-state plan because of the state-tax deduction, they should look for low fees, good diversified investment options, and ease of use. Utah’s plan is great on all three counts and the author loves the “Enable Gifting” feature, which allows generous relatives to use a simple weblink to give to a student directly.
What if I am Starting Late or Cannot Save Much?
You can open a 529 with as little as $25 in most cases, so almost any amount of money is enough to get started and will help defray the expenses of college down the road.
Starting late is better than not starting at all. While it is ideal to start as soon as the child has a Social Security number, some parents cannot start saving until later. Even if a child is in middle school, the parents can still get five to seven years of growth to reduce the cost of college. Even as juniors or seniors in high school, it may not be too late. It may not make sense to put in money for the first couple years of college since it’ll have to be pulled out immediately and not have any chance to grow (the exception is in cases of a state-tax deduction, because it may make sense to put money in and pull it out immediately for college expenses just to get the state deduction). However, in high school, saving for the last year or two of college would still provide for three to five years of potential growth.
An Update on 529 Plans with the 2018 Tax Law
We’ve been getting a lot of questions on potential changes for 529 plans with the new tax law, especially using 529 plans to pay for private schools. The new tax law allows 529 plans to be used for up to $10,000 per year in K-12 tuition expenses, giving more families an opportunity to save tax-free for private schools. Earnings on qualified withdrawals for K-12 expenses are tax-free at a federal level right now for everyone.
However, the withdrawals may or may not be state tax-free (for example, they are not currently qualified in my home state of Illinois), and any tax benefits taken on deposits may be subject to recapture. Each state has its own laws concerning 529 plans and, while every state has passed legislation making qualified withdrawals for higher education tax-free, the same is not necessarily true for K-12 expenses.
So, if you’re considering withdrawing money to pay for tuition at a K-12 school, be sure to contact the respective program and your accountants and/or financial advisors to determine whether there will be state tax penalties.
Nirav Batavia serves as co-Managing Partner of Forum Financial Management and co-Director of Forum’s Investment Committee as well as Chief Technology Officer. Forum Financial Management is a Registered Investment Advisor with $3.3 Billion in assets under management.
The information in this article is intended to serve as a basis for further discussion with your professional advisors. Although great effort has been taken to provide accurate numbers and explanations, this information should not be relied upon for making investment decisions.