College Savings Plans:
I have pulled information together from several articles…so…sit back and prepare to be amazed.
to saving for retirement, your biggest financial challenge is probably saving
for your kids' college education. How do you know how much to save? How much
will a college education cost when Junior turns 18? What if you save all of
this money and then he decides to tour
Now, in addition to the Coverdell Education Savings Account, there is another way to save that can provide even better benefits. A 529 college savings plan is a very simple way to save money for your kids' (or anyone else's) college education. The benefits are tremendous. Here are some of the heavy hitters:
And there are still more benefits.
this article, we'll look at the rules for 529
The Cost of College
If you have small children and haven't been told how much a college education is going to cost in 15 years, then you should make sure you're sitting down when you read this. Conservative estimates put four years at a public (yes, public) university in 15 years at about $100,000 or more. Try this calculator to find out how much it will be for other time periods.
You may never have thought you could get excited about big sums of money you won't be spending on yourself until you read about this new college savings plan. The 529 plan may well be the best thing in college savings plans since... well, anything. This plan offers the most painless way to save money for higher education to date. And if the child decides not to go to college, you can roll it over to someone else in the family that does want to go, including yourself! The benefits of this plan far outweigh any drawbacks it may have -- which aren't many. Let's look at how it works.
The 529 Plan
The 529 Plan (named after its section number in the IRS code) is a savings plan for college education. You have a couple of options when you open an account.
The idea, with either option, is that the investment earnings will grow to meet the higher costs of future education. The savings account option is typically considered the more attractive of the two and is what we will focus on in this article.
The 529 plan is a state-sponsored investment program. That is, the state sets up the plan with an asset management company of its choice, and you open a 529 account with that asset management company according to the state's predetermined plan features. You are the owner of the account, and the child for whom the account is set up is the beneficiary. You won't deal directly with the state, but rather with the asset management/investment company.
Because each state can control some of the features of its own plan, there are variations from state to state. Most plans follow the same general scheme (and federal requirements), but make sure you compare plans among states other than your own. Most states don't require residency in order to participate, so shop around different states for the best deal. Click here for information that will help you compare states and choose the right plan.
In the next section, we'll look at some of the things that make the 529 plan so attractive.
Prepaid Tuition Option
With the prepaid tuition option, parents, grandparents and anyone else can lock in today’s tuition rates, and the program will pay future college tuition at any of the state’s eligible colleges or universities. The program will also pay an equal amount of money to private or out-of-state institutions.
You will usually deal directly with a state agency when setting up a prepaid tuition plan. You buy tuition units (or years) either with a one-time lump sum purchase or monthly installments. If you opt for the prepaid route, then that money is pooled with other prepaid sums from other account owners and invested by the program in order to grow to meet (or even exceed) future tuition needs.
The prepaid tuition account also works differently in regard to eligibility for financial aid. The money paid out from the prepaid tuition 529 account offsets the eligibility for financial aid dollar-for-dollar. In other words, if your prepaid tuition account pays $10,000 for tuition one year, then your child will be seen as needing $10,000 less for financial aid.
The Benefits: Tax Treatment
The tax exemption on 529 account earnings is in effect at least until 2011, which is when it can revert to the original plan where the earnings are taxed at the child's rate. It is very likely that Congress will revisit the 529 issue and vote to make the tax-free status permanent prior to that date.
The Benefits: Account Control
The Benefits: Income Eligibility
The Benefits: How the Money Can Be Used
The Benefits: Investment Control
With all of those pros, there have to be cons, but they're pretty acceptable and easy to live with. Here they are:
...the 529 account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution towards your child's college costs will include 5.6 percent, or less, of the value of your 529 account for each academic year. This is actually much better than the 35 percent assessment against money that is in your child's name or in a custodial account.
The only real drawback comes in when calculating eligibility the second year. At this point, 50 percent of the money that was withdrawn from the 529 account the first year shows up on your child's tax return. This decreases your child's eligibility for the next year by 50 percent of that amount. For example, if you withdraw $10,000 from the account to pay for college expenses the first year, then $5,000 (50 percent of the total) will show up as the child's taxable income. That will decrease your child's eligibility the following year by $2,500, because there is a 50 percent eligibility assessment on the child's tax return from the prior year. (Remember -- we're talking about tax laws -- all of this can change.)
If the student owns the 529 account, which is what happens when a custodial account has been transferred to a 529 account, then the amount of the account will greatly affect his or her eligibility for financial aid. Because the student owns the account and it is one of the student's assets, a 35 percent assessment against those assets kicks in.
If you are investment-savvy, then handing over control of your 529 account investments may be a difficult thing for you to do. If you're not quite so on top of things in the investment world, however, you may find trusting your money to a professional investment manager a little comforting. Remember that a money management company is actually managing the investments. The state works with those companies to set up your selection of investment options. The good news is that some very well-known money management companies are managing many state programs. Your comfort level may increase just knowing the reputation of those handling your account.
The choices you have for investing your 529 account funds are determined by the investment manager of the plan. Many states are expanding their investment choices, making it easier for most people to find a plan that suits both their goals and their acceptable risk levels.
In addition to mutual funds, most state plans are also beginning to offer several age-based portfolios of mutual funds that include conservative, moderate, and aggressive asset allocations. These types of investment choices start out in stocks when your child is very young and shift gradually to bonds and money-market funds as your child gets closer to college-age. The idea behind the age-based portfolios is to be aggressive when you have more time, but to keep your investment safer as it gets closer to the time that you need to cash out. The perk behind this scheme is that you don't have to remember to shift the investments yourself. You can buy it and then forget about it. In addition to the age-based portfolios, you may have the option of 100-percent stock and fixed-income funds that can be used alongside an age-based portfolio in order to fine-tune the overall allocations to suit your needs.
If you decide later on that you're not happy with the way your account is growing, you have the option of rolling the money over into another state's 529 plan with no penalty. Keep in mind that if you're getting a state tax break by using your own state's plan then you'll lose that by moving to another state's plan. You can always keep the account in your state and open second account in another state. There is no limit to the number of accounts you can have -- even for the same child!
Each state has different investment options and this is a very important part of setting up your plan. It pays to investigate several state's plans in order to find the best deal not only for investment options but for the other requirements and limitations of the plan. Let's go over the how to pick the right plan...
Choosing the Right Plan
Choosing the right 529 plan is not much easier than choosing anything else in financial world. It takes some research, some luck, and the ability to accept some level of risk. The variations in state plans don't make the process any easier. Here are few guidelines that can get you started:
Researching 529 Plans
The Kiplinger Web site offers information about the best deals for 529 plans.
SavingForCollege.com is also a great resource for all kinds of information about 529 plans. It provides state-specific information and links to state programs.
Another issue is the age limitation. There are a few states that may require your child to use the money prior to a certain age, or that may require that the child be under a certain age in order for you to be able to open an account. There may even be limits to how long the accounts can remain open without any withdrawals.
Money that goes into a custodial account is an irrevocable gift belonging to the child. The advantages have been that putting money into the account lowers the family's total taxable income, and that the first $750 in earnings are tax-free and the next $750 in earnings are taxed at the child's tax rate (usually around 10 percent). The disadvantages are that you can't take the money back in the event of an emergency. The money can be used for the child's benefit but not for your own or your family's (i.e., unemployment, vacation, home improvements). You can probably get away with using the money that way, but the child has the legal right to fight the decision. Another disadvantage is that the child can spend the money on anything once he or she reaches either 18 or 21 depending on your state's age requirement. Financial aid eligibility creates yet another disadvantage for custodial accounts because when the money is in the child's name, then 35 percent of it will be considered an asset available for college costs, possibly making the child ineligible for financial aid.
a Custodial Account to a 529
You can convert your existing custodial account to a 529 account, but it won't have the same benefits. The problem is that the money in the custodial accounts belongs to the child and therefore will still belong to the child when it is converted to the 529. That means that the child will still gain control of the account at 18 or 21 and have the opportunity to cash out (paying taxes and penalties) and then use the money for anything.
Now known as Coverdell Education Savings Accounts, ESAs were improved significantly in 2002 because Congress increased the annual contribution limit from $500 to $2,000. Like 529 plans, ESA earnings are tax-free when used for education expenses, and they are considered the parents' asset so they don't adversely affect financial aid eligibility.
They do have some advantages over 529 plans, including more control over your investments and the ability to use the money for private elementary or secondary school expenses.
Their disadvantages are the limitations on parents' income. For single tax payers, the eligibility phases out for incomes between $95,000 and $110,000. For married taxpayers filing jointly, eligibility phases out between $190,000 and $220,000. Another disadvantage is that the funds have to be used for education by the time the beneficiary turns 30. Like the 529, there is a 10-percent penalty if the money is used for anything other than education expenses.
For more information on 529 plans and other college savings topics, give me a call or email.