As a small business owner, doesn’t it feel great when you’re earning money and have extra cash to invest in your future? If you have kids at home, college savings can feel daunting.
The cost of post-secondary education continues to outpace inflation. According to FinAid.org, the historical average college tuition inflation rate was 8%, compared with 3.2% for inflation. More recently, tuition inflation rates have been hovering below 6% annually and inflation overall is about 2%. In fact, some universities report a 0% inflation rate in recent years. Nonetheless, college is expensive.
College will cost how much?
According to CNBC, Fidelity has a new 2K rule of thumb: If you intend to cover ½ the cost of college tuition at a 4-year public university, multiply your child’s age by $2,000. Aim to have at least that much set aside in college savings. Using this example, a 10-year old should have $20,000 in the 529 plan account. Obviously, if you intend to send your child to a more expensive school or cover more than ½ the cost, the target amount should be higher.
The College Board’s 2016 study “Trends in College Pricing” indicates the average cost of four-year public and private colleges per year for undergraduate tuition, room, and board. Public in-state undergrads average $17,100, and private school undergrads average $43,440 for the 2016-17 school year. By 2024, those averages are expected to climb to $34,000 and $76,000, respectively.
Many of my financial planning clients ask a similar question: how should I direct my savings? When there are so many competing priorities – emergency fund, paying off debt, saving for retirement, etc. – adding education savings to the list may seem too difficult. Generally, I encourage families to focus on emergency savings and debt reduction. We also look at retirement plan contributions. THEN, and only THEN, do we explore 529 plan funding.
Two Types of 529 Plans
In the world of 529 plans, there are two primary types: Prepaid and Savings.
Prepaid plans historically were state-run and allowed you to purchase tuition credits at today’s rates. Private College 529 has emerged with a different kind of prepaid plan: nearly 300 private colleges and universities have joined forces to offer tuition certificates. There is no market risk, since investment performance is tied to tuition inflation.
The more common 529 Savings Plans are available nationwide and are further subdivided into broker and direct plans. Broker-sold plans can be purchased through an investment advisor and are professionally managed by that advisor, while direct plans are generally less expensive but more of the “DIY” version. You, as the account owner, decide how to allocate investments in direct plans. Many of these state-run savings plans offer age-based options that gradually become more conservative as the beneficiary ages. The market performance of any 529 Savings plan is tied to the underlying investment.
Debunking the Myths
Now that you have a feel for the types of 529 plans, let’s play a game of true or false.
1. You must invest in the 529 plan of your home state. FALSE
Several states offer a state income tax deduction if you invest in your home state plan, but a few states provide tax parity whereby you receive the state income tax deduction even if you contribute to an outside state’s plan. Examples of these parity states include: Arizona, Kansas, and Missouri.
2. You will lose money if your child (the beneficiary) doesn’t go to college. FALSE
The amount you initially contribute to a 529 plan can be withdrawn without penalty. Only the “gain” or appreciation is subject to income tax and 10% penalty for non-qualified (“NQ”) distributions. Let’s suppose you contributed $50,000 to a 529 plan and the balance grew to $60,000. You only pay income tax and 10% penalty on the $10,000 gain of NQ distributions. Furthermore, if your son or daughter will not be attending college, you can transfer 529 funds to another family member without penalty. There is no age or income limit for a beneficiary.
3. A 529 plan allows you to save for future higher education costs and simultaneously make a tax-advantaged investment. TRUE
Contributions to 529 plans grow tax-deferred, and qualified distributions are tax-free. By definition, qualified 529 plan withdrawals include tuition, fees, books, equipment and supplies. Room and board is also considered “qualified” if the student is enrolled at least half-time at a university or vocational school.
4. Many 529 plans allow out-of-state investors, but other benefits may apply to investors who participate in their state-sponsored plans. TRUE
Choosing your home state plan may result in matching grants and scholarships, protection from creditors, and exemption from state financial aid calculations. If you reside in a parity state, lower fees and superior historical investment performance may entice you to choose an out-of-state plan. Regardless of which state plan you choose, there is a downside: 529 plan balances impact the federal student aid calculation for need-based aid and reduce eligibility for select federal tax credits.
I personally believe the benefits of 529 plans outweigh the disadvantages and have numerous college planning resources thru my other firm, WorthyNest. If you found this article helpful, please share it with a friend.
Deborah Meyer, CPA/PFS, CFP®
Originally published July 12, 2017. Updated September 25, 2017.