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Demystifying the 529 College Savings Plan

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The latest version of a national study found that 70% of parents have begun saving for their child’s college education, although only 56% of these parents have a financial plan to meet their saving goals. On average, parents started saving for college when their child was five years old and have an average of $35,300 in a 529 college savings plan. [1]

What is the 529 College Savings Plan?

A 529 plan is a tax-advantaged account, meaning there is no federal income tax on investment gains, and qualified distributions (defined in IRS publication 970) are income tax-free. When used at an institution participating in the US Federal Student Aid program, eligible expenses include:

  1. Tuition and fees
  2. Books, supplies, and equipment
  3. Expenses for special needs services that are required to facilitate the student’s enrollment or attendance
  4. If the student is enrolled at least half time, room and board may also be a qualified expense.

529 plans come in two distinct types: investment-based or pre-paid tuition plans. Investment-based plans allow for a flexible contribution schedule over time, generate a market-based return on your investment, and offer the greatest amount of flexibility within the eligible expense guidelines above. These plans are generally appropriate for those comfortable with market-risk and a sufficient hold period.

Pre-paid plans, by contrast, usually come with a rigid contribution schedule. They allow investors to lock in the current cost of tuition by pre-purchasing a certain number of credit hours at a particular university or college system (if the student decides to go a different school, plans include a calculation for a cash payout option that can be used for any qualified educational expense). Prepaid plans are generally appropriate for those looking to avoid market risk.

Benefits of a 529 plan

First, “because 529 college savings plan assets are considered parental assets, they are factored into federal financial aid formulas at a maximum rate of about 5.6%.” [2] That’s going to mean the beneficiary will be eligible for more aid than if they had a student asset.

Generally, the investors who will benefit most are in a relatively high tax rate with a relatively long holding period so that the tax benefits can compound over time. Contributions are considered “completed gifts” for estate tax purposes, and there is a provision within the tax code allowing them to gift up to 5 years worth of their annual giving limit into a 529 plan without eating into one’s lifetime gift-tax exclusion.

Limitations of a 529 plan

Among the primary limitations is that 529 distributions must be made within the same tax year that the expense is incurred. Also, tax-free distributions coordinate with other tax credits and scholarships. For example, if you receive a tax-free scholarship or tuition assistance, you may need to re-characterize your 529 distribution to become a taxable one; undermining the original incentive for opening a 529 plan.

The most well known limitation is the dreaded 10% penalty. So, if your child isn’t likely to attend college, a 529 may be too limiting for your family.

When should I start?

Like all savings plans, starting early, and contributing regularly are the best ways to ensure you meet your goals. Especially if you’re starting an account for a young child, it might be wise to include a Roth IRA and non-qualified accounts to diversify your savings, and avoid penalties, in case they decide college isn’t the route for them.

Please contact us to have a conversation about saving for your child’s college education.

[1] https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/PR/CSI-2018-Executive-Summary.pdf
[2] https://institutional.fidelity.com/app/item/RD_13569_26294.html