Presented by STEPHEN LAFRANCE, CFP®, MBA
Since it is National 529 Day, we thought it would be appropriate to take a closer look at saving for education through a 529 plan. We will also compare a few other options that may make sense for you, depending on your specific situation.
What is a 529 Plan?
A 529 plan is generally a qualified tuition program created by the government in the 90s to incentivize saving for educational goals. The “529” comes from the location of the rules governing the program in section 529 of the Internal Revenue Code.
There are two types of 529 plans: prepaid tuition and savings plans. The latter is the most popular as the prepaid plans allow you to prepay tuition at today’s prices, typically reserved for participating in-state public universities. On the other hand, savings plans are much less restrictive and more popular than prepaid plans.
While the IRS governs the plans, individual states create them to allow for states to tailor them to their needs, specific to their university system. While most states offer at least one plan, there are multiple plans in some states. However, you can use any 529 plan, regardless of its originating state. Check with your state’s plan for potential tax deductions on contributions or tax-free earnings on qualified withdrawals. If you don’t have a specific state tax benefit, there could be a better option with another state’s plan.
Every 529 plan will have a different lineup of investment options that you can use with varying costs and features. You’ll want to make sure you choose a plan with investment options that match your risk tolerance and goals. Most 529 plans offer age-based investment options that adjust as your child gets older and closer to using funds, which is helpful as you want to make sure the aggressiveness of the portfolio matches the time horizon of the goal. These model portfolios are ideal, given a limit of two changes to investment elections per year in 529 plans.
Fees & Expenses
The difference in fees and expenses can drastically separate some plans. Some may offer only one option, while others may offer several share classes of investments. You’ll want to consult with your financial advisor to determine which is best based on your goals. Depending on the plan, advisors are compensated differently, so ask your advisor how they are paid. Some state plans are not available for use by financial advisors. Ask your financial advisor about the differences between advisor-sold plans and non-advisor-sold plans. You may prefer to pay a commission to your advisor through the investment options. Alternatively, you may choose to find a fee-only plan. Your advisor charges you a flat fee either one time or annually to advise you on investment options and/or assist with processing contributions/withdrawals. If you are confident that you can make those decisions and want to handle the operational portion, then a non-advisor sold plan might be best for you.
Whether you choose a plan through an advisor or not, choosing a reputable financial institution with good customer service is essential. It’s also important to consider ease of use. Is their website easy to navigate? Can you process contributions and withdrawals online? Can you make address changes, automatic investment changes, or add a bank account online? Do you want to do all those things yourself or have an advisor do it? As a reminder, whether you end up using one or not, it’s essential to consult with a financial advisor when making these decisions.
One of the most important aspects to understand about 529s is what expenses are qualified, meaning you don’t pay taxes on the growth of the funds when you make a withdrawal. That is the primary driver for why people choose to use a 529 versus other savings vehicles. Still, it can add some complexity as you have to keep track of expenses and make sure you match withdrawals with eligible costs.
These qualified expenses have always included the total cost of tuition, fees, books, equipment, and room and board of accredited colleges or universities in the United States. More recently, the plans were expanded to allow $10,000 per year for K-12 expenses and a $10,000 lifetime limit per beneficiary for student loan repayment. You can also move funds to pay off up to $10,000 of student loans for the beneficiary’s siblings. In addition, there is an existing plan called a Coverdell ESA designed to save for K-12 expenses, but these are obsolete with the expansion of 529s to include K-12 costs.
One of the benefits of 529s is that anyone can contribute to them, whether the parents, grandparents, friends or even the beneficiary themselves. This flexibility means you don’t have to open separate accounts for each contributor, and all the funds can be held for each beneficiary. However, siblings do need to have individual accounts. You can always move funds for a 529 to the account of a family member without penalty. We won’t delve into specific rules here, but these transfers can be to parents, in-laws, and even first cousins.
Grandparents & FAFSA
If the students plan to fill out the FAFSA (Free Application for Federal Student Aid), it would be best to open 529s in the grandparents’ name to avoid including these assets in the FAFSA. Students’ and parents’ assets are included, but grandparents are not. This is a popular planning strategy for wealthy grandparents trying to efficiently draw down their estate with the least taxes or penalties. There are other factors to consider with that strategy, so it is best to consult with a financial advisor to help determine the best course of action for your specific situation. Also, keep in mind the estate and tax ramifications if the grandparents pass away still owning the assets. If keeping the assets out of the parents’ name seems attractive, consult with a financial advisor or estate planning attorney to understand what else might need to be done.
Should you use a 529?
After walking through the specifics of what a 529 is, and the existing rules and limitations, many ask if all the headache is worth it? The most significant benefit you can get from a 529 is the compounding time value of money. Given that the goal starts at birth, usually as an 18-22 year funding goal, that time horizon begins shrinking immediately. As that happens, the ability for the funds to grow substantially starts shrinking as well. Even if you start at birth, a typical age-based portfolio will be predominantly fixed income ten years before the end of the spending goal for a child that begins college on time and earns a four-year degree.
If you start saving at birth, the tax savings and the time value of money are compelling reasons to use a 529 if you are confident your child will go to a four-year university. However, if that isn’t a certainty in your mind, or you are getting a late start to saving, there might be some other alternatives that I alluded to earlier.
Custodial Account Option (UTMA \ UGMA)
If you trust your child or think you will be able to trust them when they reach adulthood, a custodial account may be a great option. The funds in the account are deemed irrevocable gifts to the child but can be used for their benefit before they can take control at 18 or 21 (depending on the state), including to pay for college. Earnings are taxed at your child’s tax rate, subject to kiddie tax rules, but for the most part, the taxes are virtually zero throughout their time as a minor if appropriately managed. If you are seriously considering this option, it would be best to consult your tax advisor to see if the kiddie tax rules would apply, etc.
While technically not an account typically used for college savings, if you can contribute to a Roth IRA, you might want to consider this option. You can always take out your contributions to a Roth IRA free of taxes. While they would be subject to income tax, the earnings are spared the tax penalty if used for education. It may not be the best option, but if you want to use a few different options for funding the goal, you should consider this.
If you aren’t sure your child will go to college, aren’t willing to trust them with your hard-earned money when they reach adulthood, and aren’t eligible to contribute to a Roth IRA, maybe a simple savings or taxable investment account would be best. The one point I want to get across is that no matter what type of account you choose, the most critical decision you can make is to save for your goals.
As I have said many times, should you have questions about how this applies to you, please consult with the appropriate advisor, whether related to taxes, investments, or legal concerns.
Engage with the Blakely Financial team at WWW.BLAKELYFINANCIAL.COM to see what other financial tips we can provide for your financial well-being.
Blakely Financial, Inc. is an independent financial planning and investment management firm that provides clarity, insight, and guidance to help our clients attain their financial goals.
Securities and advisory services offered through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser.
Authored by the Investment Research team at Commonwealth Financial Network