529 plans: tips to save for your children’s college

529 plans- find tips to save for your children’s college.

529 plans hold the majority of college savings in the US.

According to a Sallie Mae study – How American Save for College 2018, It showed that the average amount of saving for college increased $18,135 (11%) in 2018 compared to $16,380 in 2016. Approximately 56% of parents who expected their children to attend college have saved for their children’s college. Parents with children ages 0-6 have saved $6,108. Those with children ages 7-12 and 13-17 have saved $14,032 and $22,985 respectively. The majority of the college savings were held in 529 plans.  

According to ISS Market Intelligent data, 529 industry assets reached $346.3 billions at the end of 2019 compared to $88.5 billions in 2008. Over 11 years, the 529 assets remarkably increased 391% representing a 13.2% compound annual growth rate. 

What is the 529 plan?

The 529 plan is a savings plan designed to encourage savings for education. It is legally known as a “qualified tuition plan”. It is sponsored by states, state agencies, educational institutions and authorized by the Internal Revenue Code Section 529.

There are 2 types of 529 plans –  the prepaid tuition plan and the education savings plan. All 50 states of the U.S and the District of Columbia sponsor at least one type of the 529 plan. 

The  education savings plan vs the prepaid tuition plan

	Education Savings plans	Prepaid Tuition Plan
	You as an account saver can invest in 529 plans for beneficiaries’ future education of colleges, university, elementary and middle schools	You as an account holder can purchase future units or credits at the participating colleges or universities (usually public or in-state) at current prices for your beneficiaries.  You contribute to a prepaid tuition plan of a state’s plan in return to lock for future college tuition at today’s rate.
Investment options	Your investment options include mutual funds, exchange-traded funds (ETFs) and principal protected bank products.	There are no individual investment options. The money you contribute will be put in a general fund. Then, the plan program manager will pool and invest the funds in plan investments to meet the obligations of participants.
Distributions	Distributions can be used at any college or university in the U.S, and may also include non U.S colleges or universities Unused amounts by the beneficiary can be used by other beneficiaries such as the beneficiary’s siblings, the account saver’s college expenses and the account savers’ grandchildren.	Prepaid tuition plan savings may not cover the full tuition cost if the beneficiary does not attend the participating college or university or out of state college.
Sponsorship	All education saving plans are sponsored by the state government	Most prepaid tuition plans are sponsored by the state government
Residency requirements	Only a few have residency requirements for account holders and beneficiaries.	You and your beneficiaries are required to meet residency requirements
Guarantee	Plan investments are not guaranteed by state governments and the federal government. However, some principal protected plan products may be insured by the FDIC.  Since, all investments have risks. You could lose some or the entire investment.	Plans are not guaranteed by the federal government. Some states may or may not guarantee the funds paid to the prepaid tuition plan that they sponsor. You could lose your prepaid tuition fund since it is not guaranteed and if the sponsor has a financial shortfall.
Room and board	Education plan savings can be used to pay for future room and board, books, computers, software (if required) and mandatory fees at colleges or universities.	Prepaid tuition plan savings cannot be used to pay for future room and board at colleges and  universities.
Elementary and middle schools	Savings can be used to pay up to $10,000 per year per beneficiary for tuition at any public, private and religious elementary and middle school.	Savings cannot be used to prepay for elementary and middle schools.
Fees	Education savings plans may  charge enrollment, application fees and ongoing administrative fees, annual account maintenance fees, ongoing program management fee and ongoing  asset management fees (depending on the investment option you select).  Education saving plans purchased from a broker are typically subject to additional fees such as sale loads or charges at the time of investment or redemption and ongoing distribution fees.    Some of these fees are collected by sponsor states. Others are collected by the fund manager.	Prepaid tuition plans may charge enrollment, application fees and ongoing administrative fees.

Is a prepaid tuition plan a better option?

A prepaid tuition plan may be an option if you know exactly where your children will attend college. Since prepaid tuition allows you to lock your children’s future college tuition costs at today’s rate, you can save a lot on college costs. According to the National Center for Education Statistics on Tuition costs of colleges and universities, the college costs including tuition, room, board and other fees for undergraduates between 2008 – 2009 and 2018-2019 increased by 28% for public schools and 19% for private non-profit schools after inflation adjustments. However, those costs decreased by 6% for private for-profit schools in the same period.   

However, you should consider the prepaid tuition plan’s drawbacks. For instance, prepaid tuition plans may have residency requirements. Therefore, if you plan to open a prepaid plan, you should make sure that you meet a 529 prepaid plan’s residency requirements. Here are some states with prepaid tuition plans: Florida, Maryland, Michigan, Mississippi, Nevada, Pennsylvania, Taxes, and Washington.

In addition, 529 prepaid plans cannot be used to pay for elementary and middle schools. 529 prepaid plans also cannot be used to pay for room and board. Moreover, 529 prepaid plans may not cover the full tuition cost if the beneficiary does not attend the participating college/university or out of state colleges. 

How to manage a 529 plan investment?

It is important to have a 529 plan management strategy. Your investment in 529 plans can be reduced by multiple fees. Therefore, you should figure out its fees before opening a 529 savings plan. In addition, 529 plan investments also have certain investment options and restrictions. You are not permitted to freely make investment changes. Typically, when you make a new contribution, you select investment options for that contribution. However, for the previously contributed amount, you can make investment changes twice per calendar year or when you change the beneficiary. 

On the other hand, non-qualified withdrawals from 529 plans are subject to your state tax, federal income tax, and may also include an additional 10% tax penalty.  Therefore, before investing in a 529 plan, you should do research and ask many questions to make sure that you choose the right option. 

Typically, when your beneficiaries get closer to college age, your investment portfolio will automatically shift to more conservative investments which are less risky and your returns may be lower. If you use your 529 education savings to pay for your beneficiary’s tuition in elementary or middle schools, you will probably plan to withdraw the savings soon. Then, you may choose less riskier investments. Note that all investments have risks, therefore, you should choose to invest wisely. 

How to save fees while investing in 529 plans?

By investing in direct-sold education savings plans, account holders can invest without paying additional broker fees. Some education savings plans may waive or reduce administrative or management fees if account savers maintain a large amount balance, participate in automatic contribution plans, or are residents of the state sponsoring the 529 plans. Some fees may be waived by some 529 plans if you select paperless or electronic delivery document option or enroll online. 

The 529 plan contribution limit may vary by different states.  Your 529 plan contribution is treated as a gift and may be subject to gift taxes. To avoid the federal gift tax, you can contribute no more than $15,000 per year per beneficiary in 2020. On the other hand, you can avoid gift tax with a front-load 529 plan contributing $75,000 or a maximum of 5 years of gift tax at once per account. 

A direct-sold 529 plan vs an advisor-sold 529 plan?

Advisors of direct-sold 529 plans receive fee-based compensation while those of advisor-sold plans receive commission-based compensation on the funds that clients invest.  Direct-sold 529 plans offer more flexible plans for clients. In addition, a direct-sold 529 plan is typically cheaper than an advisor-sold 529 plan. According to a Morningstar report, for an age-based portfolio, the average fee for a direct-sold 529 plan was 0.35% at the end of 2019 compared to the fee of 0.87% for an advisor-sold plan in the same period. As of a result, direct-sold plans  became more popular. MorningStar’s 529 College Saving Landscape report shows that direct sold plans increased by 7.3% yearly from December 2015 to March 2020, while the advisor-sold plan increased only by 2.8% in the same period. 

What are 529 plans’ tax benefits?

Investing in 529 plans may get some tax benefits. The tax benefits may vary depending on the states and the 529 plans. However, you should consider consulting with your tax advisor because there may be tax implications for 529 plans in different years. 

Many states offer tax deductible contributions from state income tax or matching grants if eligible. However, 529 plan contributions are not tax deductible for federal tax. 

Contributions to 529 plans are after-tax contributions. The investment growth of contributions and earnings are tax-free. The longer you keep your money in the 529 plan, the bigger the funds will grow. 529 plan earnings are tax-free for qualified withdrawals. However, if withdrawals are not qualified, they are subject to state tax, federal tax and an additional 10% tax penalty on earnings.

Does investing in 529 plans affect financial aid eligibility?

Depending on different educational institutions, investing in a 529 plan will generally affect students’ financial aid eligibility for higher education. It also may affect the future students’ financial aid eligibility for elementary and middle schools. Therefore, you may need to consider the possible effects of investing in a 529 plan on the students’ financial aid needs such as student loans. 

For 529 plans owned by parents, the first $10,000 in savings will not be counted towards the expected family contribution or parental assets on FAFSA. As of result, the first $10,000 will not reduce the student’s financial aid fund. However, if the 529 plan savings is more than the $10,000 allowance, a maximum of 5.64% of parental assets will be counted on the student’s income; and will reduce the student’s financial aid by that amount. If the grandparents own the plan and pay for grandchildren, 50% of grandparental assets will be counted on the students’ income and will reduce the student’s financial aid. You can check how much your financial aid will be affected due to 529 plans by using  the financial aid calculator.

529 plans vs Roth IRA

Are there other tax-favored savings for colleges?

While a 529 plan helps you to save money for colleges, a Roth IRA may also help. You can have both a 529 account and Roth IRA to save for college. Similar to the 529 plan, Roth IRA contributions are after-tax contributions. So, with both the 529 plan and the Roth IRA,  investment growth is tax-free. You will not pay tax on qualified distributions. 

Since you open your own account and make your own investment decisions, Roth IRAs offer more flexible investment options compared to 529 plans. You can get a higher return with a Roth IRA if you are comfortable making  your own investment decisions and know how to invest wisely. However, note that a higher return comes with a higher risk. In addition,  Roth IRAs have some drawbacks. 

529 plans vs Roth IRA

2020-2021	529 saving plans	Roth IRAs
Contribution limit	$15,000 per year per beneficiary	$6,000 if age under 50 and $7,000 if age 50 or above
Income restrictions	No income restrictions	MAGI less than $140,000 for singles, and $208,000 for married couples
Investment options	529 plans limit investment options to mutual funds, ETFs, and principal protected bank products. You cannot invest in individual stocks	Roth IRAs offer more flexible investment options including individual stocks.
Investment growth	Tax free	Tax free
Distribution	Tax free for qualified higher education expenses. Up to $10,000 can be used to pay for elementary, middle school and existing student loans.	Distribution can be used for any expenses.  If your account is at least 5 years old, and you are 59 ½ or above, then, contributions and earnings withdrawals are tax free. However, you can withdraw up to your contribution any time for any reason without paying tax.

Questions and Answers – 529 plans: tips to save for your children’s college

1. What happens to 529 plans if they are not used?

According to Internal Revenue Service’s guidance on recent 529 education saving plan changes, you can use up to $10,000 of the 529 assets to pay for public, private, or religious elementary, middle schools. Also, you can use up to $10,000 ( this is a lifetime limit, not annual limit) to pay existing student loans. In addition, you as a 529 account saver can change the 529 plan beneficiaries as long as they are part of your family such as the beneficiaries’ sibling, first cousin, grandparent, grandchildren, aunt, uncle and yourself. 

In case, the beneficiary drops a class during a semester for some reason, the 529 savings contribution must be refunded to the beneficiary’s account within 60 days to avoid tax. This refund or redistribution will not be counted against the contribution limit. 

In addition, the designated beneficiary’s 529 saving plan can be rolled over to an ABLE account. ABLE accounts are tax-favored accounts for people who become disabled before age 26 and are designed to help families to save for disability-related expenses.  

2. Can you lose money in 529 plans?

If your 529 asset is not used by your beneficiary, you can use the unused asset for other beneficiaries of your family and yourself for qualified education costs. 

However, since 529 saving plan investments are not guaranteed and insured, you may lose some portion or the entire of your money in 529 saving investments. All investments have risks, so you should consider investing wisely. 

3. Can you cash out from 529 plans?

529 plans are designed for savings for education costs. Contributions to 529 plans are after-tax contributions. The investment growth of contributions and earnings are tax-free.  529 plan earnings are tax-free if the withdrawals are qualified. However, if withdrawals are not qualified, they are subject to state tax, federal tax and an additional 10% tax penalty on earnings.

If the beneficiaries get a full college scholarship, the penalty for cashing out of the 529 plan may be waived. 

4. What is the average return for 529 plans?

You may choose to invest amongst investment options including mutual funds, exchange-traded funds (ETFs) and principal protected bank products. You cannot invest in individual stocks in 529 plan investments. The average return for 529 can be 6% or more. According to ISS Market Intelligent data, 529 industry assets reached $346.3 billions at the end of 2019 compared to $88.5 billions in 2008. Over 11 years, the 529 assets remarkably increased 391% representing a 13.2% compound annual growth rate. 

5. Do you need an advisor to open a 529 plan?

You do not need an advisor to open a 529 plan, however you should consider multiple factors before investing in a 529 plan. 

Your investment in 529 plans can be reduced by multiple fees. In addition, 529 plans may have some restrictions. Also, 529 plan investments have certain investment options. You are not permitted to freely make investment changes. Since all investments have risks and they are not guaranteed, you may lose some portion or the entire of money in 529 investments  

On the other hand, non-qualified withdrawals from 529 plans are subject to your state tax, federal income tax, and may be subject to an additional 10% tax penalty.  Therefore, before investing in a 529 plan, you should do research and ask many questions to make sure that you choose the right option. 

Investing in 529 plans may get some tax benefits. The tax benefits may vary depending on the states and the 529 plans. However, you should consider consulting with your tax advisor because there may be tax implications for 529 plans in different years. 

Sources: 

U.S Security and Exchange Commission. An Introduction to 529 Plans. 

https://www.sec.gov/reportspubs/investor-publications/investorpubsintro529htm.html. Accessed on June 11, 2011.