Tips on tax-advantaged college investing strategies.
Well, you’re not alone. As a matter of fact, a listener named Phil wrote in about this subject wanting to get some direction for his 8-year-old boy's college plan.
Well, Phil, it is never to early to start and you are asking an important question. Parents of youngsters worry about this same thing every day. I am one of them. With the rising costs of education and other expenses it becomes more worrisome for many every day. And it should! The College Board estimates that the average costs for college increase at double the rate of inflation. At 8%, the cost will double in 9 years! And in difficult economic times where people are just trying to put food on the table and keep a roof over their families’ heads, college savings is so distant a notion it may as well not exist. Luckily there is some hope for some with the help of a 529 plan.
529 Plan Basics
The 529 Plan is a tax-advantaged investment that promotes and encourages saving for higher education. This plan is often favored over traditional savings methods because of its tax advantages. There are two types of 529 plans that I'll discuss: the prepaid plan and the savings plan.
Prepaid 529 Plans
The prepaid plan makes it possible for someone to buy tuition credits at the current rate, in today's dollars, and save these to be used sometime in the future. These essentially eliminate the worry associated with inflation and rising costs.
Savings 529 Plans
The savings plan is meant to be used as a tax-advantaged savings plan, specifically designed to cover the costs associated with higher education. There are a variety of these and it is important to understand that they usually carry investment risk and contain penalty provisions if the monies are withdrawn for other uses beyond educational purposes.
There are some that offer a stable value and guaranteed options, some that are "risk based" and retain the same equity-to-fixed-income ratio despite age, and then there are the "age based" asset allocation plans that will automatically shift the plan assets to a more conservative posture the closer your child gets to college.
Allowable 529 Expenses
There is a good deal of flexibility here. The money in a 529 Plan can be used for the college costs of the plan beneficiary including
room and board
fees and supplies
at any accredited college, university or vocational school in the United States as well as a handful of foreign universities. The only school expense that you cannot pay with money from a 529 plan is the payment of any student loan or the interest accumulated from student loans.
There’s also a way to the get money out if it isn’t all used for educational expenses, but there could be penalties. The money can be withdrawn by the controller of the account, which is usually the donor, but will be subject to income tax and a 10% penalty for early withdrawal.
Exceptions to the Withdrawal Penalty
The plan does provided for some exceptions to the general rule however. Should the beneficiary become disabled to the point they can no longer perform a gainful activity, in other words, work for a living, the money can be withdrawn without penalty. Or if the plan beneficiary dies, the money could be passed on to any other named beneficiary or back to the donor.
There are even more benefits for the 529 Plan.
Tax deductions. First, several states offer tax deductions to the donors for these contributions. No federal breaks however are available.
Tax-free growth. Second, and at the heart of the plan is that the principal growth and the beneficiaries distributions are all tax-exempt.
Donor control. Third, the donor continues to control the account. The beneficiary has no right to touch the money, and in most cases the donor can withdrawal the cash at any point. But remember those penalties!
Other reasons to enroll in the program are well...it’s easy. Unlike some college programs there are no hoops to jump through. You don’t have to do intensive research and accounting to figure out what you have and where you’re at financially. You just fill out a simple account form and make a contribution. Plus, the start-up deposit requirements are usually low and everyone is eligible, as there aren’t any restrictions on age or income.
However there are some disadvantages as well.
State fees. Some state plans charge excessive fees that nearly off-set the rewards and earnings.
Withdrawal Penalties on Unused Funds. And, should one not use all the money there is that little 10% penalty fee to deal with.
Financial Aid Limits. Also, being named as the beneficiary of a 529 Plan can limit your financial aid eligibility as the account value could be counted as an asset. If you think this may be an issue you can always have the owner or donor of the plan be someone besides the student or parent.
Here's a tip: Naming a grandparent the owner for example may be a great way to benefit the financial aid application since it will not show the student had a claim on the account.
With the cost of higher education, well, higher, you should really start thinking about plans such as the 529 Plan to help offset the expense of giving your children an education and chance at a better life. I have added a few additional links on the show notes to help--like a College Cost Calculator.
And for helping us with the question for this episode, Phil will be getting a copy of my audiobook, The Discipined Investor, now available as an audiobook at iTunes and Audible.com. Pick up a copy today, and start on the road to becoming a disciplined investor.
As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.