In today’s uncertain economy, it’s not easy for Americans to plan for the future. But one thing parents should know better than to scrimp on is their child’s education.
With tuition costs steadily rising and with more students are competing for aid and scholarships, it’s more important than ever to prepare for the expense of college. And a good tool out there to help is a 529 plan. While 529 plans do have their flaws, they are one of the better college savings options currently available, and as such, are something anyone planning to contribute to a child’s college education should know about.
If you are unfamiliar with 529 plans and have a child who is college-bound, here is some introductory required reading: 529 plans allow you to invest as much as $300,000 (this varies by state—some allow less, some more) towards a chosen beneficiary’s college education, tax-free. That beneficiary can be virtually anyone, including yourself, and unused funds can be rolled over to a new account for a family member.
Here’s the real impact: Even if you only save a $300 a month from the time your child enrolls in kindergarten until he or she graduates high school, you can squirrel away nearly $50,000. And without paying a dime of taxes on that college fund! And most importantly of all, anyone can contribute on behalf of any beneficiary and anyone with a Social Security number can be a beneficiary, regardless of age. That provides for tremendous flexibility to meet almost any educational needs.
I must note, however, that this is not a sneaky way for you to save retirement money tax-free outside of, say, an IRA. The plans’ tax-free distributions are only for qualified school-related expenses—non-qualified distributions will be hit with federal income tax, plus a 10% penalty, and may also incur tax penalties at the state level, depending on the state.
There are two basic plans to choose from: College Savings Plans and Prepaid Tuition Plans.
College Savings Plans (CSP) allow you to invest in portfolios of investment options that are offered by individual states, although you don’t have to invest in your own state’s plan. Your CSP account’s savings can then be used to pay for tuition and expenses at any accredited college or university in the U.S., and even some overseas.
Prepaid Tuition Plans (PTP), by contrast, let you put money aside to pay the tuition at a school in the state that offers the plan and (in some cases) lock in a price for tuition years before your plan’s beneficiary matriculates.
These plans grow tax-free as long as you keep money invested in them. And, like a Roth IRA, qualified distributions are exempt from federal taxes, a formerly temporary provision that was made permanent in 2006 as part of the Pension Protection Act passed by Congress.
As the contributor, you, not the beneficiary, remain in control of the plan—you determine where to invest the monies and when distributions are made, and if you so desire, you can cancel the plan and get your money back (with some penalties, of course).
When chosing a 529 plan, it’s very important to look for special tax breaks. One of the most valuable is the break your home state may offer. Residents of many states that offer 529 plans are often allowed to deduct 529 contributions from their taxes when investing in their home state’s plan (Arizona, Kansas, Maine, Missouri and Pennsylvania provide state-tax benefits to residents investing in any 529 plan, in state or out).
Flexibility is also key, so you can also make a change in plans if you need to. If you find a plan that improves on one you’ve already invested in (or you move and want to keep getting those state tax deductions), most states will allow you to transfer an existing 529 once a year. There is also currently no limit on owning multiple plans in different states — effectively allowing you to exceed the $300,000 per beneficiary account cap. If you decide to buy into a 529 plan, go directly to the source and not through an independent broker, as their fees can cut greatly into your earning potential.
However, there are a few catches to be aware of before you invest. One is the greed of individual states, which, in some cases, will tax residents who move their money out of their home state’s plan and into another.
Another big concern is how the colleges and universities your beneficiary is applying to will consider 529s when making financial aid decisions — some schools will factor in 529 plan assets when making their decision, while others will not. There is the possibility that a prospective student with a 529 plan may not be regarded as eligible for a given school’s financial aid program — something decidedly worth checking into if you think your beneficiary would otherwise qualify for aid. This is especially true if you are considering a PTP — assets so invested are viewed differently by aid officers than they are in CSPs, and for every dollar in a PTP, any financial aid will be reduced by the same amount.
As far as the federal financial aid application (FAFSA) rules go, 529 plans with students or parents as the account owner are viewed as parental assets and will decrease any aid by no more than 5.64% of the account value, currently. The FAFSA rules and rates can change from year to year, however.
Also keep in mind that the landscape for 529s is not set in stone, and rules may be altered over the course of your investment if you begin socking away education funding early in your child’s life. In September 2009, the Treasury Department released a report recommending a number of changes to 529s, mostly aimed towards making the plans more attractive and beneficial to low-and middle-income families — they are already quite popular with more affluent investors. Specifically, the recommendations included extending state-tax benefits to all 529 investors, whether they participate in their home state’s plan or not, putting a cap on overall contributions for each beneficiary, reducing the plans’ tax benefits for higher-income investors to free up more federal resources for lower-income families, and providing age-based index options in each plan. How soon and to what extent these recommendations (especially the proposed removal of home state biases, as many states are desperate to refill their coffers) will be acted upon remains to be seen.
For more information about these plans, visit the Saving for College website (www.Savingforcollege.com), which ranks and reviews each state’s plan options, and provides general information and tools to help calculate the benefits. Vanguard also supplies some information on its site — go to the “Research Funds & Stocks” tab and look under “529 Portfolios.”
My best advice is to do some comparison shopping to find out which plan will best suit your purposes and those of your chosen beneficiary before settling for your home state’s plan.
As a Vanguard investor, you’ve got world-class funds at your disposal. But which funds aren’t coming back, and which ones will lead the recovery? Vanguard can’t tell you, but I can. These are the best Vanguard funds to buy — and the ones you should dump.