Every May, years of all-night study sessions and grueling examinations endured by thousands of young men and women culminate with graduation and the receipt of a four-year college degree. While more and more young men and women are attending college, the cost to attend continues to skyrocket. The Institute for College Access and Success reports that as of 2012, over 70% of students graduated four-year colleges with student debt. 66% of graduates from public colleges had debt (with an average balance of $26,000), 75% of graduates from private not-for-profit colleges had debt (with an average balance of $32,000) and 88% of graduates from private for-profit colleges had loans (with an average balance of $40,000). Despite the cost, the value of a college education remains – the Bureau of Labor Statistics reports that in 2015, college graduates enjoyed an overall unemployment rate of less than half of high school graduates and earn more than double the wages. The bottom line is simple – more students have access to a four-year college education, which positions them in the long run significantly ahead of their peers who do not attain a four-year degree, but costs a significant sum, which acts as a millstone around the neck for many graduates.
To help better manage the cost of higher education, many families set up and fund 529 college savings plans to help defray (or in some cases, fully pay for) the cost of education, helping to minimize financial hardship before, during or after college. Federally established by the Small Business Job Protection Act of 1996, 529 plans are tax advantaged investment vehicles designed to encourage tax free saving for higher education expenses of a designated beneficiary. Two types of 529 plans exist: prepaid tuition programs and the more common, college investing plans.
Since college savings plans were initially created by states under state law prior to the enactment of the 529 plan statute, all 529 plans are sponsored by a state, though most permit both residents and non-residents to participate in their program (there may be state income tax benefits to participating in the plan of your home state).
Types of Plans
Ten states offer prepaid tuition programs, such as the U.Plan Prepaid Tuition Program in Massachusetts, which permit the purchase of Tuition Certificates in $300 increments to be used towards tuition and mandatory fees at a large list of participating colleges within the Commonwealth. The primary benefit of this program is locking in the percentage of tuition and mandatory fees paid for by your contribution at today’s prices– meaning your purchase is guaranteed to keep pace with the inflation of tuition and fees. The growth factor of your initial investment is not taxable if the certificates are exchanged for attendance at a participating school. For example, the purchase of ten certificates today equates to 7.25% of one year’s tuition at Berklee College of Music (2016-2017 tuition & fees of $41,398), 67.97% of one year’s tuition at Roxbury Community College (2016-2017 tuition & fees of $4,415), or 6.26% of one year’s tuition at Smith College (2016-2017 tuition & fees of $47,904). The school the beneficiary will attend does not have to be determined until the student makes his/her college attendance decision. In the event the beneficiary attends a non-participating school or decides not to attend college, you will receive your investment plus interest at a rate of the growth in the Consumer Price Index (CPI) without penalty. The interest received will be taxable.
The more prevalent 529 plan used today are college investing plans, such as the U.Fund College Investing Plan, in Massachusetts, which is managed by Fidelity Investments. These plans function in many regards like a 401(k)/403(b) account. Each state’s plan (most only sponsor one plan) in most cases is managed and administered by an investment custodian, such as American Funds, Fidelity Investments, T. Rowe Price or Vanguard (several states, including Utah, are not run by a fund company and have several different fund families among the investment options). Most plans offer age-based investment options (akin to target-date retirement mutual funds), which are typically pooled investment vehicles comprised of mutual funds managed by the custodian, that become more conservatively invested as the beneficiary’s moves closer to college age. Many custodians also permit the account owner (the person who sets up the account) to invest the plan balance according to their own investment allocation from the available fund options within the plan.
Funds invested in 529 college investing plans grow tax-deferred and withdrawals are tax-free, provided they are used for Qualified Higher Education Expenses paid to a US institution or a qualified foreign institution, including required college or other post-secondary tuition and fees. Generally, anything that is not a mandatory expense is excluded. The gain associated with any funds withdrawn from a 529 college investing plan not used for Qualified Higher Education Expenses is subject to ordinary income taxes and a 10% penalty.
Who can setup and fund a 529 plan?
Anyone can establish a 529 plan for a beneficiary. Most plans are owned by parents and grandparents. Per a 2014 survey released by Fidelity Investments, 72% of grandparents feel that it is important to help pay for their grandchildren’s college education; 529 plans are a great way for grandparents to lend a helping hand. Once established, anyone can make contributions to a 529 plan setup for a beneficiary.
Tax considerations and other benefits.
Annually, anyone can contribute up to $14,000 ($28,000 for married couples who elect to split gifts) per year into a 529 college savings plan without making a taxable gift . Donors may also make an election under 529(c)(2)(B) on their gift tax return to make five years’ worth of contributions up front without making a taxable gift ($70,000 for single filers, $140,000 for couples who elect to split gifts).
Over 30 states, including the District of Columbia offer state tax benefits for contributions to 529 plans. For example, Massachusetts affords single filers a state tax deduction up to the first $1,000 and joint filers a deduction up to the first $2,000 contributed to either of the state’s two plans. The value of this deduction should be considered but not be the overriding reason to choose one plan over another (the $2,000 deduction in MA is worth $102, since the MA income tax rate is 5.10%).
Many plans offer additional incentives to entice enrollment in their plan. For example, the MA 529 college investing plan offers a credit card, where 2% of all eligible spending will be contributed directly into your 529 plan. Other plans offer the ability for you to make contributions via direct deposit from your paycheck. Plans such as the Nevada plan enable you to link your Upromise shopping loyalty account to your 529 plan directing rebates and incentives into your plan account.
Which plan should I choose?
Many factors should be considered when choosing the optimal plan. First, as with all investments, fees and investment choices should be considered. Next, you should consider whether any state income tax benefits are available to you for establishing an account with your state’s plan. Lastly, consider whether you are likely to take advantage of any additional plan benefits, such as a rewards credit card or shopping program, associated with some plans.
Okay, now what?
Saving for college is a daunting task for most families. Setting up 529 plans is a great first step, but its benefits can only be realized if a funding plan is established and maintained. Many families commit 50% of the money received from birthdays, religious celebrations and holidays to a 529 plan. Other families establish periodic investments coordinated with their payroll into the plans. Another choice is to dedicate a portion of tax refunds or other cash windfalls into the plans.
College savings is an integral part of the financial planning process for most families. Consider reaching out to a holistic wealth manager to develop a college savings plan coordinated with a retirement savings plan and customized based upon your resources to ensure you are on track to meet your goals.