This month we have a guest blog post from Dave Fernandez, CFP® who is a native of Arizona and has over 20 years of financial services experience. He started his financial services career in 1995, is a NAPFA Registered Financial Advisor and is the owner of a fee only financial planning and wealth management firm, Wealth Engineering, located in Scottsdale.
529 College Saving Plans
Many of my clients have children, grandchildren or other loved ones who plan to attend college in the future. However, it is becoming more challenging each year to plan for the cost of college as the costs are increasing at more than double the rate of inflation. This has been a consistent increase over the last 38 years. To put this cost increase in perspective, below is a chart comparing the rates of inflation over the last 38 years (since 1978) for college tuition & fees, medical care, new cars, and the overall consumer price index (CPI):
Chart courtesy of www.dshort.com
Here are some current average “all in” college costs (tuition, fees, room and board) in today’s dollars:
- Public University – In-State – $20,100/year
- Public University – Out-of-State – $35,400/year
- Private University – $45,400/year
- Harvard, Stanford, Yale or similar = approximately $54,500/year
I can understand why many students have turned to student loans to partially or fully pay for college. In fact, today two-thirds of students graduating from American colleges/universities are finishing school with some level of debt. I have read that the average borrower is $29,400 in the red. Also, total student loan debt outstanding recently crossed the $1.2 trillion mark!
The good news is that if you have the means to save for a loved one that wants to attend college, there is an excellent savings vehicle for this purpose called the 529 College Savings Plan.
What is a 529 plan?
A 529 college savings plan is a tax deferred savings plan sponsored by a state to allow families to save funds for future college costs. They share some characteristics similar to IRAs and Roth IRAs. There are two types of 529 plans: prepaid tuition plans and savings plans. Prepaid plans are plans that allow you to prepay tuition at a particular college in advance at today’s prices. The most common type of plan is the 529 savings plan and that will be the focus of this article.
What are the main benefits of 529 savings plan?
One of the greatest benefits of this type of plan is that all contributions and earnings grow tax deferred like an IRA. And as long as the funds are used for qualified education expenses, all distributions from the plan are tax-free like a Roth IRA.
What are qualified educations expenses?
Qualified education expenses include tuition, fees, books, supplies, and equipment (computers) required for study at any accredited college, university or vocational school in the United States and some international schools. This can also include room and board.
How much can I contribute to one of these plans?
Most plans will allow you to make total contributions of up to $200,000 to $300,000 over the life of the plan. Since these contributions are considered gifts to your child, grandchild or other loved one, you will want to ensure any annual gifts stay below the annual gift tax exemption amount of $14,000. For those interested in making a larger lump sum gift, 529 plans specifically allow a gift exemption of 5 years’ worth of annual gifts to be made in one year or $70,000 (5 x $14,000).
These contributions are permanent gifts for estate tax purposes. Thus, for those with large estates, this is another way to gift family assets down the line but still maintain control of the gift if you are also the owner of the 529 plan.
Who is the owner of the 529 plan?
There is always one adult owner and one beneficiary (future college student) per 529 plan. Any adult can be the owner of the account. This is typically a parent or grandparent, but could include any adult family member or friend.
What if I save for college but my child receives a scholarship?
529 plans allow you to change the beneficiary of the account. Thus, if you have another child that needs more financial assistance you could make a change to designate them as the new beneficiary. Or, if the child may pursue a graduate degree, they could use the funds for later educational funding.
What happens if we use the funds for something other than a qualifying college expense?
Contributions and earnings are distributed on a pro-rated basis. You will have to pay taxes on any of the earnings distributed and also pay a 10% withdrawal penalty on the distributed earnings. There is no penalty or taxes on the distribution of original contributions.
You mentioned these are state run plans. Does that mean I need to invest in my home state’s 529 plan and must my child go to college in this same state?
Another great benefit of 529 plans is that you can invest in any state 529 plan and your child can go to any school anywhere in the United States, or certain schools outside the U.S. For example, you may live in Arizona, but you could decide to contribute to a 529 plan in California and your child may decide to go to school in Colorado.
If almost every state has a 529 plan, which one should I choose?
Out of all of the state 529 plans, there are a handful which are consistently ranked near the top each year for being well run plans, with excellent investment choices and reasonable fees. The one I highly recommend is the 529 plan run by the state of Nevada and administered by Vanguard. I personally use this plan for my two kids.
Morningstar recently ranked the best and worst 529 Plans for 2016. You can read the article here: http://www.investopedia.com/articles/personal-finance/111616/best-and-worst-529-plans-2016-morningstar.asp Morningstar has consistently given Vanguard’s 529 plan a top rating every year. Also, as the 529 plan has grown in assets, Vanguard continues to reduce the expense costs of the investment choices. There are other great choices for 529 plans as discussed in the above article if you prefer a different investment custodian.
Another great website resource to research and learn about saving for college and 529 College Savings Plans is at http://www.savingforcollege.com/.
Are there any additional tax benefits besides tax deferred growth and tax-free distributions?
Many states allow you to take a deduction against your state income tax return for any contributions made to a 529 plan each year. In Arizona, they recently increased this deduction to $2,000 for an individual and $4,000 if married and filing taxes jointly. Arizona is also very flexible in that you can make a contribution to any 529 plan in any state and still use the Arizona deduction against your state income taxes.
Below is a link to a chart of all current state tax deductions available by each state. You will want to review this with your financial advisor to help you determine which 529 Plan may be the best option considering your state of residence. http://www.finaid.org/savings/state529deductions.phtml
What are my contributions invested in within the 529 plan?
Most plans have a mix of mutual funds and age-based funds to invest in. Your financial advisor can help you determine the best asset allocation for each child. Note, 529 plans typically limit investment exchanges to twice per year.
About The Author
Dave Fernandez, CFP® is a native of Arizona and has over 20 years of experience in the financial services industry. He started his financial services career in 1995. As a NAPFA Registered Financial Advisor, Dave owns a fee only financial planning and wealth management firm, in Scottsdale, Arizona called “Wealth Engineering.”
Wealth Engineering, LLC