The Top Four Things You Need to Know about 529 Plans
There are two irrefutable truths; kids like Halloween candy and college is expensive. In 2018, the cost of a four-year public in-state college would cost $20,770 on average. A four-year private college would cost almost $47,000 a year ($46,950*). Multiply those numbers by four and you’re looking at spending $100,000 on the low and around $200,000 on the high end.
If your child is close to college now, I’m sure you’re cringing at those numbers. If you have a young child now, it may get much worse. Inflation for college is much higher than the normal average inflation rate. Saving often and early may be the best course of action. 529 plans can be a good option, but there are a few things that you should understand before setting up a 529 plan.
1) Each State has their Own Plan
Each state does sponsor their own 529 college savings plan. For example, Massachusetts’ college savings plan is through Fidelity’s UFund and Virginia’s 529 plan is through American Funds’ College America plan. A common misconception is that you are restricted to participate in the state plan where you reside. If you live in Massachusetts, you are not required to use the Massachusetts sponsored UFund through Fidelity. You can use the plan that’s in Ohio or Delaware if you’re comfortable with that provider.
One item to note, some states do over a state tax deduction, but you do have to use the state sponsored plan. For example, Massachusetts overs a $1,000 state tax deduction for individuals and a $2,000 deduction for those that are married filing jointly.
2) Tax Benefits
Other than the above mentioned potential state tax deduction, 529 plans do offer greater tax efficiency compared to an investment account or savings account. 529 plans work somewhat similar to Roth IRAs in terms of tax treatment. After tax dollars are invested into the 529 plan and then the investments will grow tax free. As long as the distributions will be tax free as long as the distributions are used for approved college expenses.
3) What Can You Do with the Funds if You Don’t Need It
What if your child is athletically gifted or incredibly smart and gets a full scholarship? What if they decide to go to a trade school instead? What happens with the money that’s been invested in the 529 plan? With a 529 plan, you do have some flexibility.
529 plans may cover some expenses that scholarships won’t such as a computer. Since computers don’t cost $200,000, there may be money left in the 529 plan. You do have the ability to transfer the beneficiary of the 529 plan to another child (brother/sister or other family member).
529 plan funds are made up of principal (money that has been contributed) and interest or earnings. Funds can be withdrawn from the 529 plan as a non-qualified withdrawal. The earnings portion would be subject to taxes plus a 10% penalty. There are some exceptions to this penalty such as a child attending a military academy, a disability or death.
4) How 529 Plans Affect Financial Aid
The Free Application for Financial Student Aid (FAFSA) form is pretty complicated. Figuring out how a 529 plan fits into a child’s ability to collect student aid is based on a few variables. The owner of the 529 plan is important. If the owner of is a parent, the 529 plan may reduce the financial aid by a maximum of 5.64% of the asset value. Withdrawals are not reported as student or parent income.
If the owner is a non-parent, the value of the 529 does not count against financial aid, but the withdrawals are counted as student income (up to 50% of the withdrawal).
Overall, 529 plans can be excellent tax efficient savings vehicles to help a child pay for college in the future. Be sure to understand your specific state’s tax treatments of the accounts and look to have a backup plan in case your child doesn’t need the 529 plan.
Sources:
*https://www.collegeraptor.com/find-colleges/articles/affordability-college-cost/average-college-costs-2017-2018/