If you or your children are planning on higher education, then the best time to save is now. With college expenses skyrocketing, American families can no longer afford to wait.
According to financial guru Suze Ormand, the best way to save for higher education is with a 529 College Savings Plan. And Suze is not alone in her thinking: Since 529 plans first became exempt from federal taxes in 2002, the market for them has ballooned into a multi-billion dollar business.
With dozens of different 529 Plans available today, you are facing a broad and admittedly complex investment world. This article will help you negotiate the terrain before picking the best place for you and your money.
So what is a 529 Plan?
Named after section 529 of the IRS tax code, 529 Plans are state-sponsored, tax-deferred savings plans dedicated to higher education expenses. Some enable you to cover just the cost of tuition and fees, while others include room, board and books.
All fifty states and the District of Columbia sponsor at least one 529 Plan. Recently, a group of private colleges and universities have come together to sponsor a 529 Plan as well.
How does a 529 Plan work?
There are two flavors of 529 Plans: 529 college savings plans and 529 prepaid tuition plans.
Prepaid plans provide a tuition guarantee based on the present day value of in-state college tuition and fees. Essentially you are buying tomorrow’s tuition at today’s costs.
A college savings plans is a managed investment portfolio, where your money – and that of your fellow Plan buyers – is invested in some savings vehicle, usually mutual funds of stocks or bonds.
The investment risk of a college savings plan is slightly higher than with a prepaid plan, since you are not guaranteed a return that covers your tuition. But as with any investment, a higher risk means a higher potential reward. In fact, a well-planned and early-invested college savings plan can provide you with a great deal more than just tuition.
What if I buy a plan in my state, but my child or I end up going to college somewhere else?
A common misconception of 529 Plans is that they are a worthwhile investment only if you plan to attend the local state school. In reality, 529 Plans – and especially college savings plans – offer a great deal of flexibility.
With a prepaid plan, you can transfer all or some of the value of your investment to a private or out-of-state school. However, since not all plans permit a full value transfer, check the terms carefully before investing.
A college savings plan, on the other hand, allows you to apply the full value of your investment to any accredited college or university in America – and even to many institutions abroad.
I’ve heard a 529 Plan can help reduce my taxes. How does that work?
The value of your 529 Plan will grow tax-free until withdrawn. Then, when the money is used to cover approved expenses, the withdrawal itself is tax-free. And if the plan continues to grow during that time, growth is taxed to the beneficiary, who is in a lower tax bracket than the plan holder.
Another way to reduce your tax burden is to invest in your own state’s 529 Plan – if it offers a tax break. Many states are now allowing you to reduce your state income tax by all or a portion of your annual investment in the plan.
How does a 529 Plan affect our financial aid?
The good news is that 529 Plans must be reported as parental – rather than student – assets, if the beneficiary is a minor child. This means that the value of your 529 Plan is assessed at a lower rate of contribution, so a potential financial aid award should not – in theory – be hit too hard.
“In theory” because the growing feeling among financial aid officers is that a 529 Plan – even if it’s from you great uncle – is a significant asset that should be weighed heavily in aid decisions.
Even still, a 529 Plan is a powerful investment when you consider that 80 percent of financial aid is based on loans rather than free grants and scholarships. With a 529 Plan, you will earn interest today rather than paying it tomorrow.
Who can contribute to my 529 Plan?
Anyone can contribute to a 529 Plan without any income limitations, including your grandparents, other relatives, friends of the family, and even your boss.
What happens if my child or I decide not to go to college at all?
You can change the beneficiary of your 529 Plan to another qualifying family member at any time. This change would allow you to avoid – or at least deter – penalties.
Federal law does impose a 10% penalty on growth only for withdrawals of non-qualified expenses. And you might find that you incur some state tax penalties as well.
Some of the plans I like say they are brokered. What does that mean?
There are essentially two ways to purchase a 529 Plan: through a broker or direct-sold. When you go through a broker, you pay commissions. To avoid these costs, you can open your own account on-line. Each 529 Plan has its own website, where you can enroll and establish a direct deposit schedule from your checking account.
Of course, if it’s that easy, you may wonder why anyone would use a broker. The answer depends on you. Do you have the time and inclination to research all the plans and to compare their benefits, fee structures and restrictions? Are you confident about your ability to weigh the estate planning implications of this investment?
Another difference is that brokered plans primarily use actively managed mutual funds while direct-sold plans use index funds. An active fund allows you to match the level of risk to your time frame for investment.
When the beneficiary is still years from university, you can invest more aggressively; when college is just around the corner, you can take a more conservative approach.
Bottom-line it for me: Which plan should I invest in?
With broker and direct-sold funds, prepaid and college savings plans, and many plans to choose from, it is no wonder your head is still spinning.
Sure, some plans perform better – even significantly better – than others. And sure, some charge lower fees. But there is still no one right answer for every American family.
You’ll need to consider your income, the number of years until college starts, your in-state tax breaks and your risk vs. reward tolerance to determine which of the 529 Plans is your best investment.