For many parents and children, now is the time of year for decisions about college enrollment. To accompany the related emotional rollercoaster, thoughts naturally will turn to how to pay for this next educational chapter. Options include student loans, merit or need-based scholarships, college work-study programs, and 529 plans. 529 plans are a solid option for those looking to assist or, possibly, even fully fund educational expenses for another person, or beneficiary. I will take a deeper dive into these plans within this article.
The most common use case for 529 plans that I see amongst my clients is when parents set up and fund these to pay for their child’s undergraduate college educational expenses. The eligible use cases for 529 funds is not limited to college expenses, though. Funds can also be used for technical, vocational, and post-graduate educational expenses. Grandparents and non-family members are eligible to set up and/or contribute financially to 529 plans as well.
Often, the decision to save for post high-school education begins years before a child attends. Ideally, savings plans should be initiated when a child is very young to leverage the benefits of investing over a decade-plus time horizon. The hope is that the money in the account grows through the investments made in the plan, and that by the time the student needs to use the funds, they can cover a good portion (or possibly all) of their educational expenses.
There are some notable benefits in using a 529 to assist in funding education expenses, including favorable tax treatment and the broad range of allowable educational funding uses.
Contributions made into a 529 grow tax free while in the account and are not taxed upon withdrawal if used to pay for qualifying education expenses. The rules surrounding what expenses are “qualified” may not be intuitive, so it is best to familiarize yourself with the definitions in advance of taking withdrawals to avoid monetary penalties.
Certain states allow a tax deduction for 529 contributions up to certain allowable limits. In Michigan, for example, the annual state tax deduction limit is set at $10,000. Because the state tax for Michigan is currently at 4.25 percent, that yields a tax savings of $425 per year.
The person establishing the 529 plan retains ownership of the assets and can direct how much gets invested, how it is invested, and who is designated as the beneficiary. For those wishing to assist with the expense of education, investing through a 529 plan offers a way to maintain control of the assets and simultaneously provide a benefit for the beneficiary. Additionally, some financial aid determination formulas weigh the value of the assets held by the student more heavily than assets held by another individual for the benefit of the student.
As stated above, the use of 529 funds is flexible, so long as they are used for qualifying educational expenses. The definition of this is broad and encompasses not just college tuition payments, but also room, board, and other equipment or needs (such as computers, books, etc.). In fact, $10,000 per beneficiary may be used for certain high-school expenses. Each state differs slightly in their rules, so it is best to check on what rules apply to your situation.
While there are certainly benefits to using a 529 plan, there are some considerations to navigating these that should be known. Considerations mainly relate to the potential for over or underfunding the plan relative to need, as well as understanding available investment options.
Because educational expenses in any given year can be unpredictable, there is the potential that the 529 might be underfunded or overfunded. If underfunded, additional monies might be needed to make up the needed difference. If a 529 has been overfunded or funds are not completely exhausted, for example, in the case of a beneficiary finishing education earlier than expected, there are steps you can take to optimize this situation and avoid being penalized. Provisions surrounding this condition allow for a shift of the plan beneficiary or, possibly, now even for the transition of 529 funds to another type of account for the beneficiary. The rules related to these conditions are complex, though, and therefore, it may be wise to obtain counsel from a qualified financial professional.
Within 529 plans, investment options can be limited or less straightforward to understand. Some of the most common choices for are age-adjusted investments which automatically “scale down” the risk as the beneficiary approaches college age (or the age at which funds will be needed). While these do provide a “hands-off” approach in managing 529 funds, investment allocations between stocks and bonds may be more aggressive or conservative than an account owner may desire at any point.
529 plans are an attractive way to save for educational expenses, and are best setup, like any savings plans, early in a child’s life to take advantage of compounded investment returns. Many plans also offer a state tax deduction to those who contribute, making the gift of education even more powerful for both the giver and the recipient. While 529 plans are easy to start and fund, there are various rules related to use of funds that must be understood and navigated appropriately to avoid undue tax and penalties. Some may choose to involve a qualified professional to assist with this effort.
I am the account owner for 529 plans for my three children. It has been very rewarding for me to help contribute to their education planning over the years and show them how using such tools can provide real benefits. The gift of helping pay for their education will certainly give them some relief from the financial burden of college expenses, which show no signs of coming down.