Essentials of 529 plans

529 plans are the most commonly used savings plan for future college expenses. Surprisingly, a recent Edward Jones survey found that only 34% of Americans could properly identify a 529 plan as a college savings tool.

With the cost of college ever increasing, proper planning by families with young children today could help those future graduates keep their debt load to a minimum and allow them to start their careers with healthy financial lives.

In my last post, we touched on a few types of accounts that you can use to save for college expenses, one of which was 529 plans. Today we will take a deeper look at 529 savings plans.

What is a 529 savings plan?

529 savings plans allow families to save for higher education expenses. An adult opens the 529 account and typically names a child or grandchild as the beneficiary . You don’t have to be a family member to open a plan for someone. The funds in the account get to grow tax deferred until they are used for higher education expenses. For you overachievers reading this post, you cannot open and contribute to a 529 plan until a child is born.  Friends of mine wanted to start saving when they had a bun in the oven!

Who sponsors 529 plans?

529 Plans are offered in most states and they are run by either the states themselves or a fund company such as Vanguard, TIAA CREF, or Fidelity.

Do I need to invest in my states plan?

This is a common misconception. You don’t have to invest in your own states 529 plan. Another misconception is that you have to use the funds in your plan for an in-state school.  You can use the funds at any qualified school in-state or out of state. If your state offers a tax deduction for contributions to a 529 it will more than likely make sense for you to use your state’s plan. If not, you are free to choose other state plans and you can focus on keeping costs down. For more information on state tax deductions and plan costs go to savingforcollege.com.

How much can I contribute?

You can contribute as much as you like up to the limits for your plan, which generally range from $300,000 to $400,000 per beneficiary. College savings should be considered in conjunction with the other components of your financial life such as retirement savings and current expenses. So long as you give less then $14,000 per person per year to a 529 account, you should’t have to worry about filing additional forms for gift tax purposes. If anyone contributes over $14,000 a year, they will need to file a gift tax form with their taxes.

What if I have a family member that wants to contribute a significant amount?

Family members can actually front load gift contributions for up to 5 years. So grandma could put $14k x 5 = $70,000 into a 529 without gift tax consequences. Anyone who front loads giving should consult their tax advisor to ensure that the front loaded gift is accounted for properly.  The main benefit of front loading a 529 plan is that the funds have more time to grow in the account.

The key is to save what you can. Don’t fret if you don’t have large amounts to save right now. Start with small contributions and increase them as you can. The sooner you start to invest, the more time the funds will have to grow. You can also ask family members to give funds to the 529 account instead of a birthday gift. Kids get so many gifts from friends at their birthdays; why not have their grandparents contribute to their education instead of buying them another matchbox car?

Where can 529 funds be spent?

So you have saved for the last 18 years and your sweet little angel, or difficult teenager, is ready to go off to college…now what? Use the funds in the 529 account tax free for qualified expenses, including tuition, books, room and board. Your student must be attending an eligible institution, which includes most accredited colleges and graduate schools as well as many professional and trade schools. Some foreign schools may also qualify.

If funds are used for non-qualified expenses, you will have to pay ordinary income tax on the earnings and more than likely also pay a 10% penalty.

If your child doesn’t use the funds you can change the beneficiary of the account to another child.   You could also simply withdrawal the funds and pay the taxes as well as the 10% penalty on the assets. If Johnny chooses not to go to school, you can cash in the 529 account put the funds toward your retirement or take the trip of a lifetime. Don’t beat yourself up if their life takes a different path than you planned, you can still support them or not…you will just be supporting Uncle Sam too with that 10% penalty.

If your child is an intellectual rockstar or athletic superstar and they get a scholarship, you won’t have to pay the 10% penalty on the unused funds in the 529 account.

529 Investment Options

Most plans offer investments in broadly diversified mutual funds. More and more plans are offering target date funds in addition to static mutual funds. Let me explain what those are for you in English rather than finance speak.

With target date funds, you choose the target year for your child to go to college. The allocation in the fund will change over time. When your child is younger the funds will invest in more stocks and as your child gets older the fund will tilt towards bonds in order to reduce the risk of losing your funds since you will be need them shortly.

With static funds, you get to choose the stock and bond allocation. Whether you choose to set it and for forget with target date funds or you choose your own investments just be sure you understand the risks you are taking.

Watch out for fees

Try to keep fees to a minimum. Depending on the type of 529 account you choose, you can expect to pay fees for program management and maintenance, underlying investment management, and perhaps for an advisor.

Program management and maintenance fees cannot be avoided but you can shop around. Increased competition amongst state plans has helped bring down these costs.

I am a big supporter of using index funds over active funds in 529 accounts to keep investment management fees to a minimum. Many target date funds are now offered with either index funds or active funds.

Should you choose to pay an advisor to help you manage a 529, know how much you are paying and make sure it is worth your while.

529 accounts are a great way to save for higher education while allowing funds to grow tax free. Another perk, you may even get a tax break for the contributions if your state offers one.  All of this and a bag of chips thanks to IRS Tax Code 529. Who said tax law isn’t fun!