Saving For Your Children Part III: 529 Plans

“If you think education is expensive, try ignorance."
― Derek Bok, Former Harvard President

“Education's purpose is to replace an empty mind with an open one." 
― Malcom Forbes, Publisher

We've discussed the advantages of various types of accounts we can use to save for our kids (Part II), and organizing our savings to maximize financial aid (Part I). Today we dive deeper into saving for higher education through 529 plans and get into exactly how much one might need to save for their kids.

You've heard the saying that all roads lead to Rome. Well, in education planning all roads will lead you through considering a 529 plan.  Let's continue on our journey of exploring saving for our children by discussing these 529 plans and how exactly they work. 529s are a relatively new invention. The IRS paved the road for them in 1996 when it created Section 529 of the Internal Revenue Code. They are designed for a specific purpose: to help individuals save for higher education in a tax-advantaged way. In some ways, 529 accounts work like Roth IRA’s. The concept is relatively simple: dollars go in after tax. If they are withdrawn for eligible educational expenses, all of the principal and growth are disbursed tax-free.

The 529 Savings Plan

529 plans can either function as pre-paid plans or savings plans. Let’s begin with the more popular savings plan. A 529 savings plan allows your family to set aside dollars in an investment account. While some states provide residents with income tax breaks for investing in their state’s plan, you can always invest in any plan you would like regardless of where you live. Funds can be used to cover tuition, fees, books, room and board and even computers and internet access. In Part I of this “Saving For My Kids” series we discussed how 529 plans affect your Expected Family Contribution. As a result of the current FAFSA system, parents may want to own the plan and have children named as the beneficiaries.

While certain limits apply to 529 savings plans, there are some aspects of relative flexibility. The first is the fact that the beneficiaries of an account can be changed (usually once per year). In conversations I’ve had with various individuals, people sometimes express the fear that their funds will be locked up if their child decides not to go to college. But reality often plays out in a more nuanced way, and you have other options for the use of your 529. If you open an account today, you may use the savings to provide for yourself, your children, or your grandchildren. While your son, Jimmy, might choose to be a carpenter, his children might all benefit from having your savings compound over the next four or five decades before they begin their higher education. On another note, Jimmy might skip college, but his sister might decide to go to grad school.

The second aspect of flexibility concerns how much you can contribute. Currently each individual may give up to $14,000/year to an account without incurring gift tax liability. This can also be front-loaded by 5 years, allowing two parents (or grandparents) to effectively give $14,000 x 2 x 5 = $140,000 to open an account and have subsequent growth withdrawn tax free. Most accounts have an overall contribution limit upward of $300,000. You can open an unlimited number of accounts.

As with most employer-sponsored defined contribution retirement plans, 529 savings plans often come with a range of investment options. Owners can choose to pick an assortment of individual funds, or simply choose a target date fund which will adjust from higher risk, higher reward investments to lower risk, lower reward funds as the date for distribution approaches.

With a savings plan, the account holder takes on the investment risk. If the market craters the account may lose significant value. There is an alternative to this: A 529 prepaid plan transfers this risk, but comes with its own trade-offs. Let's dive in to this little discussed option.

The 529 Pre-Paid Plan

The pre-paid plan is far less publicized than its sibling, the 529 savings plan. Pre-paid plans allow families to ‘lock-in’ the current cost of an education by purchasing “tuition certificates” for semesters of college education at participating institutions. Rather than guessing at what college might cost in the future, or how much will need to be saved, this plan takes the guesswork away. The idea is that you get tomorrow’s education at today’s prices. You might find the Private College 529 Plan website to be a helpful starting point if you’re considering pre-paying for college. The Plan allows you to prepay tuition for 270+ private colleges and universities, including many top tier universities such as Stanford and Duke. https://www.privatecollege529.com

States may also run their own pre-paid plans for education at their own public universities, though in the last 10 years many states closed their plans due to the increasingly high cost of promised tuition. Currently only Virginia, Maryland, Massachusetts, Mississippi, Florida, Washington, Michigan, Nevada, Illinois, Pennsylvania and Texas retain pre-paid plans for their state institutions.

Whether you select to participate in public or private school prepaid 529 plan, the caveat is that you are purchasing the education with today’s savings, and that you may have to perform significant guesswork about not only if but where beneficiaries may want to attend college. You trade investment risk and the unpredictability of cost for a commitment to a child’s education path that may not be set in stone either.

So what happens if your child’s education plans don’t turn out as you expected? You may change the beneficiary on the account, or roll funds into a 529 savings plan, but currently with the Private College 529 Plan your rollover earnings are capped at an unimpressive annual 2%. If the funds aren’t used for education expenses, taxes on earnings and a 10% withdrawal penalty will apply.

How Much Do I Save?

According to the University of California, the average cost of in-state public tuition, fees, books, room and board in California is just under $30,000 per year today. Using a 5% inflation rate for education over the next 18 years, you are looking at a four-year cost of $288,794. If you were to save for this over the course of these 18 years, with a rate of return on your savings of 7%, you would need annual savings of just under $8,000 per year (or $667/month). Of course this doesn’t account for scholarships, grants, or other financial aid. It doesn’t account for the variety of routes your children may take along their educational journey. And it doesn’t account for the change in life circumstances. But it does provide an incentive to start saving now.

One simple, yet key takeaway from this series is that the more money you make, the less financial assistance you will receive in the form of need-based grants. While families making $50,000/year may not need to plan as rigorously for college, those making $200,000+ may face a significant bill down the road. They must either plan now, or cover the cost with debt or alternate savings. If wealthy families pass the majority of college education costs on to their children, they could potentially leave them with much greater college debt than families making much less throughout their working lives.

If you would like to spend some time experimenting with various cost and saving scenarios, you can find a simple college savings calculator here: http://www.savingforcollege.com/college-savings-calculator.

Not all 529 savings plans are created equal. For this reason I’d like to provide you with a framework for choosing a solid plan for your family. In Part IV, we will explore the NY Savings Plan, the plan I opened for my child, as a model of a good plan.