By Peter Mastrantuono
Two-thirds of Americans were unaware of 529 college savings plans and nearly half of those familiar with 529 plans did not realize that they could be used to pay for K-12 schooling costs, according to a survey conducted last year by Edward Jones.
Though most Americans are primarily focused on retirement saving, the fact is that college underfunding is a retirement problem. For many parents financially unprepared for their children’s college years, retirement savings will be the first to suffer as they scramble for ways to pay for their children’s college education. This can potentially lead to a delayed retirement or reduced financial security in retirement.
Understanding 529 Plans
529 plans are tax-advantaged savings plans offered by individual states to help parents fund their children’s education. While contributions to a 529 plan are not federally tax deductible (many states offer state income tax deductions), earnings grow tax-deferred and qualified withdrawals are tax-free.
Contributions are, however, considered a gift, though they qualify for the $15,000 annual gift exclusion. For parents or grandparents looking to make a larger contribution, 529 contributions are eligible for an up-to-five-year accelerated gift tax exclusion, which means each parent or grandparent can contribute up to $75,000 per child without incurring any gift taxes.
Each state’s plan is different in terms of the tax benefits for in-state residents, maximum allowable contribution limits (anywhere from about $235,000 to over $500,000 per child) and investment choices.
Individuals are not limited to the plan offered by the state in which they live. They may elect to invest in another state’s plan if it offers more desirable features, like higher contribution ceilings or better investment alternatives. Most financial advisors have considerable experience with comparing 529 plans and identifying the ones that fit the needs and objectives of parents.
A 529 plan may be opened by any citizen or resident 18 years old or older, so, for instance, a grandparent can establish one for a grandchild, or an uncle can contribute to a 529 for his niece.
There are two types of 529 plans, prepaid tuition plans that lock in current tuition costs and investment plans that offer a range of fund investment choices. In the latter, more popular, option, 529 plan holders can build a diversified portfolio from among a menu of individual mutual fund or ETF choices, or select an age-based portfolio—a professionally-constructed diversified portfolio that adjusts its holdings to reflect an ever-shortening investment time horizon.
Withdrawals are tax-free, provided they are used to pay for qualified educational expenses (e.g., tuition, room and board, books) at eligible institutions (e.g., accredited colleges, professional and trade schools).
Parents may also withdraw up to $10,000 per student per year to pay for private K-12 tuition.
If it turns out that a child decides not to go to college, the funds can be used to pay for another child’s college education, or even a parent’s continuing education.
If the funds are used for non-qualified expenses, they will be subject to ordinary income tax plus a 10% tax penalty, though there are limited exceptions that avoid this tax penalty.
The most important thing is to start funding a 529 early in order to benefit from the magic of compounded growth. And, parents shouldn’t worry that saving through a 529 will reduce financial aid since 529 balances have minimal impact on financial aid calculations.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.
