August 29th, 2016
For families trying to save for their children’s college education, 529 college savings plans are widely hailed as a great option—perhaps the best. But are they?
The advantage to 529 plans, named for a section of the tax code, is that families can invest through these accounts without the earnings being taxed as long as the funds are used to pay for college expenses. Earnings are typically free from federal and state taxes, plus grandparents, aunts, uncles and anyone else who cares can contribute to the account.
The most popular one operates much like a 401k retirement plan because contributions are invested in stocks, bonds or money market funds. Earnings are not subject to federal taxes as long as you use the money for “qualified education” expenses–tuition, books, fees, room and board–at any accredited school.
Yet less than 3 percent of families have tax-advantaged college accounts, according to the Government Accountability Office. Using data from the Survey of Consumer Finances, the GAO figured out that the few families that do have accounts have a median income of $142,400 a year, nearly triple the national median household income.
Families with tax-advantage college accounts also had about $413,500 in assets, making them among the wealthiest group in the country—and the biggest beneficiaries of the $1.6 billion in federal tax expenditures directed at these plans.
There’s no getting around the fact that 529 plans are extraordinarily confusing, with daunting options, fees and terms that can scare off families who could benefit from the plans. Below are some things that all families should watch out for to get the most out of the best, but most underutilized, way to save for college:
Not all plans qualify for tax deductions: States sponsor 529 savings plans for a fee, but you don’t have to choose a plan where you live. Be careful in selecting plans in other states, though, because you may be giving up a tax deduction in your home state. Arizona, Kansas, Maine, Missouri and Pennsylvania are the only places where residents can get state income tax deductions for contributions to plans anywhere in the country, according to FinAid.org.
Not all states even offer tax benefits to residents. Thirty-four states and the District provide partial or full income tax deductions to residents. The District, for instance, offers income tax deductions on contributions of up to to $4,000 a year for individual and up to $8,000 for a married couple, but only money put into the plan by the account owner is deductible. (Sorry, grandma and grandpa.) Maine has one of the more restrictive rules, capping deductible contributions at $250 per child per year. Check out Savingforcollege.com to compare all state tax offerings.
Watch out for fees: A lot of the tax advantages of investing in a 529 plan can get eaten away by fees. So it’s critical to do some research. A majority of states no longer charge enrollment fees, but most require an initial contribution of at least $25 and minimum monthly deposits of $15.
The fees you really need to worry about are those charged for managing the account. The GAO found that some plans charge as much as 2.78 percent of assets as a management fee, though most plans charge well under half a percent these days.
Fund research firm Morningstar puts out an annual review of the largest 529 college savings plans that’s worth a read. The plans T. Rowe Price manages for Maryland and Alaska routinely come out on top because of their low fee structure–Maryland’s plans have total asset-based expense ratios of 0.07 percent to 0.88 percent, while Alaska’s are 0.24 percent to 0.88 percent (the lower the percent the more money you keep).
The top plans are typically those purchased directly from the state sponsor, known as direct-sold, that come with lower or fewer fees than plans purchased through a broker who expect a commission.
Some plans will waive or reduce fees if you have automatic contributions or if you’re a resident of the state sponsoring the plan. Fifteen states, including Colorado, Nevada and Maine, will match college savings up to a certain dollar amount or provide income tax credits to encourage low- to moderate-income residents to participate in their 529 plans. Nevada, for instance, provides matching grants of up to $1,500, while Maine offers $500.
“The match programs are a good start, but there need to be more structural reforms: lower fees, minimum balance and deposit requirements,” said Ezra Levin, associate director of government affairs at the Corporation for Enterprise Development (CFED). “All of those things reduce the barrier for lower and middle income families.”
How your 529 savings affect financial aid: One of the greatest concerns parents have with 529 plans is how the investments will affect their child’s eligibility for financial aid. It’s not as bad as you may think. Investments held by parents, excluding retirement and insurance accounts, are assessed at a maximum 5.64 percent rate in determining a student’s so-called Expected Family Contribution (EFC), said Scott Weingold, managing director of College Planning Network..
Say you have a 529 account worth $20,000. You must report the $20,000 as an asset on the Free Application for Federal Aid (FAFSA), which will likely increase your expected family contribution by $1,128. Plans owned by grandparents or other relatives do not have to be reported.
Family income also factors into what schools expect you to pay, but the tax-free distributions from a 529 account are not counted in the income calculation. Parents are expected to include any support their child gets from grandparents or any other adult on the FAFSA form, including any money the student receives from a grandparent-owned 529 plan. To lessen the blow, you could wait until your child’s final year in school to withdraw money from grandpa’s 529 plan, according to Savingforcollege.com.
Dealing with the risks: To get the most out of a college savings plan, financial planners recommend investing in stocks for the higher returns. Trouble is, you’ll be vulnerable to market volatility and may not have enough time to ride out downturns, Weingold said.
“We’ve seen a lot more families shy away from putting college savings in the market, especially after the meltdown in 2008,” he said. “The risk in these plans is a downside, but the potential gains is a huge upside.”
Many plans offer target date funds that move away from stocks toward safer bonds as college approaches. Even with the risks, the rewards can be substantial across the socio-economic spectrum. A Treasury Department study found that families earning less than $68,000 saved 22 percent more in a 529 plan compared to a taxable investment account, while those with income of $137,000 saved 35 percent more.
Prepaid plans are also worth a look: This other type of 529 plan lets families purchase college credits today for future use at state colleges. Families typically pay a premium over the current cost of college to offset projected tuition inflation. State sponsors pool the money families contribute into long-term investments and use the returns to pay for tuition. Whereas families assume all the risk in the more popular type of 529 plan, states generally bear the risk for prepaid 529 accounts.
There are only 11 plans open for enrollment these days. States ran into trouble during the 2008 downturn when their investments lost value and tuition climbed faster than anticipated. As a result, many shut down their programs or closed enrollment.
Most plans only cover in-state tuition and fees, so if your child decides to head out of town, the money would have to be rolled over to a sibling staying close to home. Maryland’s Prepaid College Trust, however, will pay full resident tuition and fees at an in-state public college, or an equivalent amount toward tuition at a private or out-of-state college.
Read the fine print on these contracts. Only four states, including Florida and Mississippi, guarantee that they will borrow money if needed to cover future obligations. Others like Maryland and Virginia have varying degrees of guarantees (check out FinAid.org for more info on guarantees).
The cost of prepaid plans depend on whether you want to purchase credits for a community college or university, the number of semesters and the grade the child is in when the account is opened. There are generally a few payment options available to families.
Let’s use Maryland’s plan for example. If you enrolled this year with a little one in kindergarten, you could make 144 monthly payments of $447, 12 annual payments of $5,090 or one lump-sum payment of $42,293 to cover four years in a state school in 2026.
“Families, especially those with lower incomes, often think they don’t have enough money to save,” said Felicia Gopaul, a certified financial planner and president of College Funding Resource. “Wherever you are, start.”