BACK TO SCHOOL WITH THE 529 PLAN
The summer is over and the kids are back in school. While this is a happy time for parents, it can also cause some anxiety by reminding you that life after grade school is fast approaching. Depending on how old your kids are you may be helping them with their A B C’s, in the thick of college planning, or still looking forward to elementary school when you can finish paying for daycare.
When thinking about their children’s future after high school most parents’ minds quickly turn to the thought of college and how to pay for it. One of the defining features of gen X and millennials entering the workforce has been the presence of student loan debt. If you plan for your kids to go to college, you may be wondering if there is a way to help them reduce or even eliminate the need for loans to obtain their degree.
College tuition expenses have outpaced inflation over the past 20 years. A year of tuition and fees at a public school, a public school for out-of-state students, or at a private school will run you $9,528, $21,632, or $34,699 respectively. These figures only account for tuition and don’t include the cost of room & board. Even if the price rise slows and only keeps pace with inflation, that can be a hefty chunk of change 5, 10 or 18 years down the road. By starting saving as early as you can, the power of compounding can help grow your college savings and make the eventual bill a bit easier to swallow.
Types of education savings plans
529 Plan: The most popular type of account when it comes to saving for college are 529 plans. The 529 plan is most popular and tends to be the best choice for most people because of a few attributes: tax free growth and withdrawal for qualified use, state income tax deductions for certain states, and higher contribution limits than other plans.
There are other types of accounts available where you can save for your child or dependent if you have problems with the restrictions on the 529 plan.
Coverdell Education Savings Accounts (ESA): These allow you to invest in almost any type of security vs the 529 plan’s more limited menu of funds. A downside is that the contribution limit is capped at $2,000 annually and balances must be withdrawn by the time the beneficiary reaches 30. A former benefit was the ability to use funds in the ESA for elementary and primary school as well as higher education. This benefit is lessened by the changes included in the Tax Cuts and Jobs Act of 2017 which gave the same options to holders of 529 plans.
The Uniform Gift to Minors Account (UGMA) and Uniform Transfer to Minors Account (UTMA): These are a good option for those that are unsure if their children will be attending college. These accounts don’t benefit from the favorable tax treatment that the 529 plan does, but withdrawals are taxed at the typically much lower tax bracket of the child. These are also counted as assets when calculating student aid while 529 plan values are not, which can negatively affect financial aid availability.
529 plan benefits
The attributes that make a 529 plan great are the tax advantages: deductions on contributions, tax free growth, and tax-free withdrawals. 34 states allow you to take a deduction on your state income taxes for at least some of your contributions, and no matter where you reside your contributions grow tax free and withdrawals aren’t taxed as long as they are used for covered expenses. So even if you live in a state such as Washington, which doesn’t have a state income tax, you can still benefit from the tax-free growth.
Because the 529 plans are administered by the states, they can vary in subtle ways but most are pretty similar. The two state 529 plans I am most familiar with are Idaho’s and Ohio’s and offer a good example of the different ways states can structure their plans. Both States offer a tax deduction for contributions, but Idaho offers $6,000 individual/$12,000 joint deduction, while Ohio offers a $4,000 deduction for each beneficiary. In Ohio’s plan you may pay a different fee based on the funds you select, in Idaho’s every fund charges the same 0.5% fee.
Remember that for most States, you must use that State’s plan to qualify for the tax deduction. If you live in a non-state income tax State, or one that doesn’t offer a deduction you can shop around and choose any state plan that offers the funds or fees that you like best.
Contributions to a 529 plan are considered a gift for tax purposes, so if you contribute over $15,000 to one beneficiary you will have to list the amount over $15,000 as a gift on your federal tax return. However, you can take advantage of “accelerated gifting” by giving a lump sum of 5 years’ worth ($75,000) of gifts at once without incurring gift taxes. Most people do not have the means to make this large of a donation, but if you have relatives who are looking for ways to reduce the value of their estate they can take advantage of this process as well and the $75,000 applies per beneficiary. Anyone can contribute to a beneficiary’s plan, not just their parents.
A new 529 benefit I mentioned above is the ability to withdraw 529 proceeds to pay for elementary or primary school education as well as secondary schooling. While this is a nice benefit for those looking to use a 529 plan to help pay for private school tuition, it arguably hinders the largest benefit of the plan, the tax-free growth that occurs inside the account. By withdrawing the funds early to use to pay for a private elementary school you are robbing the account of the later compounding and growth that would occur.
The 529 plan sounds like the winner, now what?
Before diving into starting up a 529 plan for your kids I recommend taking a step back to take stock of your own financial situation first. I give the same advice flight attendants give in their pre-flight safety briefing, put your own oxygen mask on first before helping those around you. Saving for your children’s education is important and it’s something you can do along with saving for your retirement and other goals, but I recommend making sure you are hitting a few benchmarks beforehand.
- Do you have a safety fund of 3-6 months expenses built up in the case of emergency?
- Are you contributing enough to your employer’s 401(k) to receive the full match amount?
- If you have some high interest debt, do you have a plan in place to pay it off before opening a 529 plan for your child?
- If you have student loans are you on track to pay them off in a reasonable time frame?
If you can answer yes to these questions and feel comfortable with your savings and investing goals, then forge ahead!
Ok, I’m ready, what do I do next?
As I mentioned above, you can’t purchase individual stocks within a 529 plan account. Each State’s plan includes a set of funds to choose from. These range from a conservative option like a savings account to an aggressive option invested in growth stocks. The fund options available to investors is an area where most states are doing a great job. Both Idaho’s and Ohio’s plans are full of the type of funds that I use and recommend: low-cost, passively managed index funds.
The goal for a passive index funds is to mirror the returns of the index it is benchmarking, such as the S&P 500. I use and recommend passive funds over active funds because studies have shown that active managers can’t reliably outperform the market year in year out, so investors are better off going with the low fee passive fund rather than the more expensive active fund.
A few things to take in mind when selecting the fund are your risk tolerance and your time horizon (e.g. how long until junior heads to college). If you are lucky enough to get started when your children are very young you can probably afford to take more risk and invest in the aggressive funds more heavily weighted to stocks. Whereas if you only have a few years until college you might want to be more conservative and divide your investments among stock funds, bond funds and savings accounts.
As always you need to take your own behavior and risk tolerance into account. If you have 15 years until you need to use the money for college then you have time to weather the ups and downs in a stock fund in order to get more growth, but if you know that your stomach can’t stand a 20%-40% drop in the value of your account without panicking then you may want to invest more conservatively. A financial planner can help advise you on the funds you should choose, as well as provide support and guidance when the markets get rocky, as they surely will. Some plans also offer the ability to work with a financial advisor as a service for an additional fee.
Ohio’s plan has another option that can take some of the guesswork out of selecting which fund to choose: target-date funds. These funds work in the same way as target-date retirement funds. You select a fund based on the year your child will graduate. In the early years the fund will be invested mostly or all in stocks, and as graduation approaches the fund gradually and automatically shifts into a more conservative posture of bonds and cash. This reduces the chances of a large drawdown just as you would need to use the money.
If you are planning to choose the funds and manage the account on your own, you should have a plan in place to revisit them regularly (quarterly, half yearly, annually), just as you would your other investments. If you are manually managing your funds you will want to adjust the portfolio to lean more conservative (and less likely to go down in value) as your child gets closer to college age. If you invest in target date funds these check-ins should not require much work other than checking on the account balance and that your deposits are still going into the account as they should.
To sum up, if you are looking to save for your children’s college education:
- Open a 529 plan for a beneficiary (your kid), probably the one offered by your State so you can take advantage of the income tax deduction.
- Deposit into the account, or better yet set up a monthly auto-deposit.
- Decide if you are going to pick the investment funds inside the plan yourself, or work with an advisor to help you.
- Feel confident about the steps you’ve taken to prepare for your children’s future!
Bonus Step: If relatives have asked about helping out with your children’s education, then let them know they can contribute to the account as well.If you have more questions about 529 plans or are curious about other education savings options you can reach me at email@example.com or by phone or text at 208-996-0375. I look forward to hearing from you!