Learning The ABCs Of 529s
On the college planning front, there are a number of tools available that can help parents invest and save to cover tuition costs for their kids.
Some, like the Uniform Gift to Minors Act (UGMA) and the Uniform Transfer to Minors Act (UTMA) custodial accounts, are taxed at the child’s lower rate but come with no restrictions on how the beneficiary must use the money. (When he turns 18 -- or 21 depending on the terms of the trust -- it’s his to blow.)
Others, like the Coverdell Education Savings Account (ESA), allow parents to put money away and pay no federal capital gains tax on the earnings if the money is used for qualifying educational expenses. But Coverdells, formerly known as Education IRAs, also come with a low annual contribution limit ($2,000) and an income cap. (Contributions start to phase out for married taxpayers who file jointly and earn more than $190,000.)
Then, of course, there’s your friendly IRA. Money from your Roth or traditional individual retirement account can be used to cover college tuition without incurring a 10 percent early withdrawal penalty -- though most financial planners advise against borrowing from your future unless you’ve got cash to spare.
Enter the 529.
Though a relative newcomer to the college savings game, these qualified tuition programs -- named after a section of the tax code -- have fast become the MVP for parents struggling to meet or beat the rising cost of higher education. Thanks to a 2006 law that made permanent the tax-free withdrawal status of 529 savings plans, and a elimination of some of the tax advantages of custodial accounts, 529s now have little competition.
“With the cost of college being what it is, to really save effectively, I think the 529 is going to be your primary vehicle, even if you do end up putting some additional money into a Coverdell or [UGMA/UTMA] taxable account,” says Joe Hurley, a certified public accountant and founder of savingsforcollege.com.
According to the nonprofit College Savings Plans Network (CSPN), more than 9 million 529 accounts have been opened, with nearly $130 billion invested as of Dec. 31, 2007.
Despite their popularity, however, 529s remain a source of confusion for many parents -- and grandparents -- struggling to save.
It’s no wonder. Since most states operate their own 529, each with its own set of investment options and fees, those looking to open an account face a staggering number of choices.
“It can be daunting and perhaps a little frustrating,” says Hurley. “You find quite a variety of investment options and many other differences between the plans that may or may not be important to you.”
How They Work
A little background and some research tools, however, can help you decide which plan – if any – best meets your needs.
For starters, there are two types of 529s: prepaid tuition plans and college savings plans.
In either case, money held in the account can be used to pay for tuition, room and board, fees, books and supplies. There are no income limits on contributions and you can participate in virtually any plan across the country, although your child is not required your to attend school in that state.
In most states, minimum contributions can be as little as $15, helping young families save slowly, according to the CSPN, and you can generally contribute as much as $300,000 (or more) per beneficiary.
Prepaid plans are currently available in 18 states, allowing parents to pay today to cover tuition costs of tomorrow, thereby locking in the cost of tuition.
According to the College Board, a nonprofit association of schools, colleges and universities, the value of the investment in a prepaid plan is guaranteed by the state to meet or exceed annual tuition inflation, which currently ranges from five to eight percent a year.
Though they involve minimal risk, prepaid plans are designed to cover the costs of tuition at an in-state public university. Your principal and earnings may not cover the cost of tuition and fees if your child decides to attend a private college or out-of-state school, notes the College Board.
Though called savings plans, 529s, are investment-based instruments.
Money placed in your account is invested (typically in mutual funds) based on your selections.
Most state-sponsored 529s offer age-based investment options in which the underlying investment becomes more conservative (bond-heavy) as the beneficiary approaches college-age. Some, too, offer stable value or a guaranteed option designed to protect an investor’s principal while providing for some investment growth, the CSPN reports.
The best part of the 529 savings plan is that the earnings grow tax deferred and withdrawals are tax-exempt, as long as the money is used for qualified education expenses. (That provision was slated to sunset in 2010 until the Pension Protection Act of 2006 made it permanent.)
You’ll owe income tax on 529 withdrawals made for non-educational expenses, plus a 10 percent federal tax penalty. Not to worry, though, if your child receives a scholarship, the earnings portion of the amount you withdraw (not the contributions) will be taxed at the beneficiary’s tax rate, but it will not be subject to the 10 percent penalty.
Another potential perk of the 529 is that if you select the plan sponsored by your home state, you may be eligible for other tax benefits.
Now for the downside.
Because 529 savings plans are investment-based, they do involve risk. There is no guarantee that your account will keep up with inflation or otherwise lose value like a common stock or mutual fund.
“You have to evaluate [529 savings plans] like you would any other investment,” says Cindy Bailey, executive director of education finance services for the College Board. “You can get into a fund that is a real dog or into a fund that is really great. You should apply the same research when you go looking at these plans as you would for any other plan.”
Don’t overlook fees and expenses, which vary dramatically and can lower your return. (According to Savingforcollege.com’s 529 fee study, Louisiana’s START 529 savings plan charges a maximum of $320 to state residents on a $10,000 investment over 10 years, while Alabama’s Higher Education 529 charges state residents up to $1,757.)
Many prepaid tuition plans charge enrollment and administrative fees, while college savings plans charge “loads” for broker-sold plans, which are essentially just a commission you pay to the brokerage. There may also be enrollment fees, annual maintenance fees of $10 to $25 and annual distribution fees, which can range between 0.25 percent and 1 percent of your account balance each year. Some of those fees go to the state and some to the financial services firms that administer the plan.
Direct-sold 529 savings plans, sold through the plan’s sponsor or program manager, often waive the load or sales fee for residents and non-residents alike.
Savingforcollege.com provides a comparison of the lowest and highest 10-year expense totals for all direct-sold 529s on its Web site.
You should also be aware that some state plans also offer limited investment options from which to choose.
Another big question for many parents is how all this potential income will affect their child’s eligibility for federal financial aid (most often in the form of student loans).
Fortunately, assets held in a 529 generally have a low impact on financial aid.
According to the College Board, savings are treated as a parental asset when aid is determined, which means that a maximum of 5.6 percent of the account’s value is factored into calculating the Expected Family Contribution (EFC) for each academic year.
“The worst scenario is to put money into your child’s name in a mutual fund or other type of taxable investment because that gets counted as their asset which is heavily assessed in the financial aid formula,” says Hurley. “529s and Coverdell ESAs are assessed very lightly regardless of whose name it is put in.”
That said, what’s not to like.
“It really encourages people to save, especially small savers who can’t imagine saving $30,000, but can imaging putting $15 away each week,” says Bailey. “It fits very nicely with a young family’s budget – and also are very good for grandparents.”