Saving for College: What Is a 529 Plan?

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What you need to know before investing in a 529 college savings plan

college savings cost

This post was updated on January 4, 2018 to include a notice issued by the Utah Educational Savings Plan following the passage of the Tax Cuts and Jobs Act of 2017.

By Brett Carolan, CFP®

When this fall’s college freshmen were born, the average cost (tuition and room and board) of a private, non-profit, four-year college was approximately $22,000 per year. Today, that cost has more than doubled to an average of over $45,000. Many top schools charge far more than the average, such as Harvey Mudd College’s $72,478 room and board price tag for 2017-2018 alone.

In general, the top tier colleges only meet financial need. Even if your high school student has a 4.0 grade point average and his or her ACT score is in the top 1 percent, you might not be awarded merit aid from the school. Given that less than one percent will receive full-ride athletic scholarships, paying for college without accumulating massive amounts of debt requires a plan.

And it’s never too early to begin crafting your college savings strategy, and 529 plans are likely to be a key component of your plan to manage the high cost of college today.

529 College Savings Series

What is a 529 plan?

Congress created the 529 college savings plan in 1996 to help families efficiently plan for college expenses. The term “529” refers to Section 529 of the Internal Revenue Service code that was created to allow for this tax-free college savings program. These plans are operated by states or educational institutions under the legal name “Qualified Tuition Program.” As a result of its creation, 529 instantly became a crucial tool for college savings and quite possibly the best investment you’ll ever make for several reasons.

college savings campus

First, think of 529 plans as pre-paying for college: Participants put money into the 529 plan each month, then withdraw it when they need to pay for college expenses. Contributions to the 529 plan are done with after-tax dollars and the plan’s earnings are exempt from federal income tax, and in most cases state income tax, as long as distributions are used for qualified educational expenses such as college tuition, room and board, textbooks, and certain other academic expenses.

According to the U.S. Securities and Exchange Commission, some states may offer additional benefits, such as matching grants, for investing in a 529 college savings plan. However, there are a handful of states that only award these benefits if you contribute to a 529 plan from your home state.

Contributions to the 529 plan are done with after-tax dollars and the plan’s earnings are exempt from federal income tax.

Perhaps most beneficial of all is how easy it is to earmark funds for your child’s academic future. Starting as early as infancy (or even before your child is born), you have the ability to save specifically for future college expenses. Having this peace of mind that a college education for your child is funded is priceless.

How to use 529 college savings

A tax-free college savings account doesn’t come without nuance, and understanding the limits of your 529 lowers the risk of a costly mistake later.

First, understand that your 529 college savings plan can cover much more than tuition. You can withdraw the funds to pay for room and board, textbooks, and other university fees. Food is included under room and board as a valid expense, but the total cost cannot exceed the allowance set forth by the school. (Be sure to check the school’s meal plan rates for comparison.) In addition, you can also purchase a computer or other tech equipment such as a printer or laptop.

college savings books

And that’s about where the flexibility ends. These funds don’t cover decking out the dorm room with gaming systems and posters, nor do they include things like gym memberships or cell phones. The account owner controls the funds until they are withdrawn. Once those funds are dispersed, however, it makes it difficult to control how the money is used. One solution is to send tuition payments directly to the school. This way, you know without a doubt that the money was spent on a legitimate expense.

Your 529 college savings plan can cover much more than tuition. You can withdraw the funds to pay for room and board, textbooks, and other university fees.

Should you withdraw 529 funds and do not use them for academic-related expenses, the money will be subjected to federal income tax plus up to a 10 percent federal tax penalty. This could quickly eat up any savings advantages you’ve earned, so be careful to put the money toward only eligible expenses.

Creating a 529 savings plan

There are two types of plans: prepaid tuition and savings plans.

college savings tuition

Anyone can open a 529 college savings plan. You can set anyone as the beneficiary—a friend, son, daughter, grandchild, or even yourself. No income restrictions limit who can open, contribute to, or benefit from a 529 plan. And there are no limits to the number of plans you can set up.

Judging the tuition trends of the past three decades, experts estimate that a four-year degree from a public school will cost upward of $200,000 by 2030.

However, plans do have limits as to how much you can contribute. Contributions cannot be more than the educational expenses of the beneficiary. If there are others fueling the fund besides yourself, keep in mind that you may have to pay gift taxes if someone contributes more than $14,000 in a year (or $28,000 from a married couple). You can front-load five years of gifts into 529 plans and will need to file the proper documents with the IRS stating this front-loading.

529 plans and college financial aid

Saving for college in your child’s name may impact financial aid based on need by increasing your EFC, or Expected Family Contribution, which is the amount that a family is expected to pay toward a cost of a college education each year. EFC can be determined through the federal government, which also determines eligibility for Pell Grants and Direct Loans. About 400 colleges, professional schools, and scholarship programs use the Institutional Method (IM) to award need-based aid based on a different calculation of EFC.

Applying for aid based off of the IM requires families to submit the College Service Scholarship Profile, which requires more information than the Free Application for Federal Student Aid or FAFSA. The EFC determined by the federal government and IM may significantly differ, with the EFC determined by the federal government generally being lower for more affluent families. Deadlines vary among colleges and states, and some award is given on a first come/first serve basis, so is also an important factor to consider.

Judging the tuition trends of the past three decades, experts estimate that a four-year degree from a public school will cost upward of $200,000 by 2030. USA Today notes that college tuition at private institutions is growing faster than the rate of inflation, with student loan balances sitting at an all-time high of $1.3 billion as of 2016. At this rate, starting a 529 college savings plan might not just be your child’s best chance at a college education—for many students, it will be their only chance.

Talk to one of our advisors to find out more about your 529 college funding options so you can start planning for your child’s future. Remember, saving now reduces borrowing later. You (and your child) will appreciate the foresight.

UPDATE (notice issued by the Utah Education Savings Plan):

“Recent federal tax law changes expand the scope of 529 plans.

Eligible K-12 expenses: Beginning on January 1, 2018, UESP account owners may take tax-free withdrawals up to $10,000 annually from their accounts for tuition expenses at public, private, or religious schools. This provision will apply to elementary, middle, and high schools. Payments for eligible K-12 expenses cannot exceed a combined total of $10,000 from all qualified tuition programs, including UESP.

ABLE rollovers: Beginning on December 23, 2017, 529 funds can be rolled over to Achieving a Better Life Experience (ABLE) accounts owned by the designated beneficiary or member of the beneficiary’s family. For Utah taxpayers who claimed a Utah state income tax credit or deduction in prior years for their contribution to a UESP account, rollovers of funds from UESP to an ABLE account will result in recapture of that Utah state income tax credit or deduction. However, Utah taxpayers who make a rollover contribution to any ABLE program may be eligible for a Utah state income tax credit.”

Brett Carolan, CFP® serves as an advisor at Brighton Jones.

Read other posts in our 529 College Savings series:


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