Some events happen in your life that change everything. Many of these events also have a major impact on your finances. I recently encountered one when my wife came into the room and told me that we were going to have a baby! It doesn’t get any better than that. We were in shock for few days, but the news finally set in, and I realized that I needed to update our financial plan ASAP!
I crunched the numbers for diapers, wipes, and car seats. I poured over our HSA numbers and healthcare coverage. Yes, life with me IS as exciting as it sounds. Then I started thinking about college savings, and I knew that 529 plans were the best place to start. A few Google searches later, I already had a headache. 529 plan rules are set up by the federal government, but the plans are managed by each individual state. Anything gets confusing when you have that many politicians involved so I decided to do the research and share the information with everyone.
I have put together the main questions that people have about 529 plans with some quick and simple answers. I will highlight the main structure of these plans to show you why they are generally the best college savings option. At the end, I will explain the best way to start a plan.
What is the purpose of a 529 plan?
529 plans are tax-advantaged savings plans that can be used for college expenses. States have separate programs, but you aren’t required to use the one offered in your state. The best use for these plans is if you have a child that is young and has more than 5 years until they will attend college. The goal is to invest money that can grow tax free for higher education expenses.
What are the tax benefits?
The easiest way to describe the benefits is by looking at a simple example. Let’s say two parents contribute $10,000 to a 529 for their child on his/her first birthday. They invest the money and it grows to $40,000 by the time the child starts college at age 18. Here is the breakdown of the tax benefits.
Year 1: Parents do not receive a Federal tax benefit. They may receive a state tax deduction if they participate in a state that offers a tax deduction. In my home state of Missouri, they would receive a $10,000 deduction on their state tax return for contributions to any state’s plan.
Years 2-17: The investment grows from $10,000 to $40,000 without any tax consequences.
Year 18: The child uses the money for qualified college expenses. No federal or state tax is paid on the gain. This is the biggest benefit. You would normally pay tax on $30,000 of investment gains which would be $4,500 for most people.
Who can contribute to an account?
Anyone! The most common form is parents or grandparents contributing for a child. However, you can contribute to a plan for yourself, your nieces and nephews, or a friend’s child.
How much can I contribute to a Plan each year?
Individuals can donate up to $14,000 per beneficiary per year (in 2017), and twice that amount if they are married and choose to split the gift. There is also a special exemption that allows donors to donate up to 5 years’ worth of gifts in one year without gift tax consequences.
What happens if my child doesn’t go to college?
If your child decides that college is for suckers, it isn’t the end of the world. The money can be transferred to a new beneficiary that doesn’t have to be your child. If there is nobody else that you can pay for to go to college, the money can be withdrawn and you would pay the taxes along with a 10% penalty on the earnings.
What investments can be set up in the Plan?
It varies by state. Most states allow you to invest in stock or bond mutual funds. Some offer prepaid tuition plans, but those are generally not as beneficial for people.
What can the money be used for?
According to the IRS, “Qualified education expenses are tuition and certain related expenses required for enrollment or attendance at an eligible educational institution.” As you can imagine, this leaves some room for interpretation. Essentially, expenses for tuition, fees, on campus room and board cost, and required classroom material are covered. Make sure to consult with a tax professional if using the funds for expenses other than tuition and fees.
What happens if they get a scholarship?
Congrats, your child receives a full ride scholarship! If you don’t want to transfer the money to another person, you are able to withdraw the money without penalties for the scholarship amount. That means that the $30,000 in our example before would be taxed like a normal investment.
How do I set up an account?
Now that you know how they work, I am sure you are dying to know how to open an account for your child! The first step would be to research the option in your own state. If your state offers a tax deduction for using their plan, it is probably the best option. Most states have 529 websites that allow you to open a plan online with your information and the beneficiary’s information.
If your state doesn’t offer a tax deduction, or you don’t like the arrangement of the plan, start researching other states. The key items to look for are plans that offer you low cost investment options and don’t charge a commission for investing. Find a plan that allows you to use the money for any school and not just that state’s schools. The most important thing is to make sure you comprehend the plan that you choose. Don’t put money into any investment that you don’t understand!
I hope this has helped you gain some knowledge of 529 plans. My last caveat about 529 plans is this…don’t sacrifice your retirement savings to pay for your child’s education. There are other ways to go to college, but not having money in retirement will put the burden right back on your children.
As always, contact me if you need any help!
Mike Zeiter, CPA/PFS