College Savings Plan (529 Account)

Over the past 30 years it has become increasingly evident that getting a college education improves everyone’s chance to be financially comfortable or even wealthy. We all want our children to have a better life than we have had. While college is not a ticket to easy street it gives our children a fighting chance in the real world. Unfortunately college tuitions are going up fast and average household income rate cannot keep pace.

In a previous blog I mentioned college savings plans and specifically referred to a 529 account. This article will focus on what a 529 account is and how it can help pay for your children’s college expenses.

What is a 529 plan?

A 529 Plan is a tax-advantaged education savings plan that is run by a state that is designed to help pay for tuition and other college expenses. Every state has at least one 529 account and many have 3 or more. Think of the 529 account as a 401k or IRA but instead of saving for retirement you’re socking away cash (and hopefully getting a good return) to pay for college. A 529 account and an IRA share many of the same benefits but they are not identical and they differ from plan to plan. Here are answers to frequently asked questions regarding the 529 account:

What are the Federal Tax benefits?

In this respect a 529 acts like a ROTH IRA. The contributions to the account are not tax deductible but if the money is pulled out to pay for college expenses the contributions and any gains will not be taxed.

What are the State Tax benefits?

Some, not all, 529 accounts will allow you to deduct your contributions for your state taxes. Of course, this benefit doesn’t mean much for those that live in states like Florida or Texas which don’t have state taxes.

Who is in control of the money?

The owner of the account retains all rights to the account. This means that even if you appoint a beneficiary (a requirement for most 529 accounts) you still dole out the money as you see fit. If your beneficiary decides not to go to college, gets a full ride scholarship, joins the military or if you decide that they just don’t deserve it, you maintain all rights to that money. Furthermore, you can pull all of your contributions out of the account at any time without penalty (unless you touch the gains).

Who can contribute to the 529 account?
Anyone. Most 529 account websites will provide a link that you can email to your friends and family that will allow them to directly deposit money into the account. Contributions to a 529 account make great gifts for babies and toddlers especially since they would rather play with a cardboard box or wrapping paper than the expensive new toy you got them.

How much maintenance is this going to take?

Generally, when you open a 529 account you are given a number of investment options. The one I recommend is the aggressive time based option. It may be called something different depending on the account. This is a management technique that takes into account the beneficiary’s age. The portfolio will be a mix of bonds, stocks, mutual funds and cash. When the beneficiary is very young it will be mostly stocks and mutual funds and little bonds and cash which is considered riskier but should provide for higher gains. As the beneficiary approaches 18 years of age the investment mix will progressively become more conservative. The manager will cycle the investments out of stocks and mutual funds and into bonds and cash to protect it from potential economic threats.

How flexible is a 529 account? What if I change my mind?

You can change the beneficiary or your investment option once a year or name multiple beneficiaries if you would like. You don't even have to wait to have children before you open a 529 account. You can open the account and name yourself as the beneficiary or your spouse, cousin, mother or father. If your child happens to get a full ride due to some academic or athletic achievement you can wait until your future grandkids are heading of to college. As long as the money goes towards college expenses there will be no penalty. If you do decide to use the money for something other than college expenses there is a penalty. That is discussed a bit more below.

Will this complicate my taxes?

Since the money you contribute is already taxed there are zero tax implications until you start distributing the money. Even when you do start taking or doling out distributions as long as they fall within the rules for a qualified college expense you will not be penalized. You also won’t receive a 1099 form to report taxable or nontaxable earnings until then.

What qualifies as a college expense?

Surprisingly, a lot qualifies as a college expense. College tuition is a no brainer but books, room, board, school supplies (paper, pens, scan-tron sheets etc). Even a laptop computer can fall into the category of qualified college expense as long as its primary purpose is school. Let’s get back to room and board for a second. This is not just a dorm room and a college cafeteria card. This can go towards an apartment or a mortgage (though not as a down payment). Groceries and dining out also count (but I wouldn’t push it by running up a large bar tab). 

What’s the limit on contributions?

Unlike a ROTH IRA, no one is excluded from using a 529 account regardless of income. Also, the contribution limit varies from state to state but it is typically a total of $300,000 per beneficiary. This means that you can contribute as much as you want annually but be careful, if you contribute too much ($13,000) you may have to pay the federal gift tax (but that is another blog entirely).

Will this impact my child’s financial aid application?

Parental assets are assessed at a maximum 5.64% when determining whether a student is eligible for financial aid. So the impact should be very small.

What if I decide not to use the 529 account for college expenses?

If the account distributions do not go to qualified college expenses than a penalty of 10% will be assessed. On top of that, if the gains on the account (anything over the total amount contributed) are used in an unqualified way taxes will also be assessed.

How do I set up a 529 account?

I suggest that you visit your bank and discuss it with someone from the investment group there. They will likely have a few to choose from that they recommend.

This was just an introduction to the 529 account. In a later blog I will dissect the 529 account, typical cost and the best benefits.

Remember, saving for your children to go to college is a high priority but you need to ensure that your retirement plan is in full swing first. The last thing your child will need when they are 30 years old and have a family of their own to take care of is the additional financial burden of supporting you through retirement.