College Savings Through 529 Plans
Ten years ago section 529 of the Internal Revenue code was enacted. The concept was to allow families to save for college funding, monies are invested after tax, grow tax free and can be withdrawn tax free for certain education expenses (primary, secondary and college expenses).
These monies can be used by any member of the family. A beneficiary must be chosen at inception of the program, but, should a child choose not to use the monies, a new beneficiary can be chosen.
There have been some changes added in order to improve these plans:
- The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 shelters the assets in a 529 from creditors after being in the plan for two years.
- The Deficit Reduction Act of 2005 improved the financial aid treatment of 529 plans, especially, prepaid tuition plans.
- The Tax Increase and Protection Act of 2005 stretched the “Kiddie Tax” from age 13 to age 17. This made custodial accounts less appealing and 529 more appealing.
Each state steps up it’s own plan. You do not have to enroll in the state you reside in. You may choose any state plan. Funds are invested into mutual funds. Unfortunately, the plans are set up by the state (government) administrators who often chose the most conservative fund options for the plan. Consequently, the investment returns have been less than overwhelming.
An alternative to these plans is to set up a separate growth fund for the kids in the parent’s name. When the child reaches 18 years the fund can be gifted to the child. Once gifted, the sale of the fund by the 18 year old, with only modest taxable income, will be taxed at 5% or even 0%.
Another advantage of a 529 plan is that it can be a great gift and estate planning tool. Wealthy grandparents can transfer assets out of their estates free of gift or estate taxes. These plans can be front end loaded for up to 5 years with a maximum amount of $120,000 for a married couple.
Parents with income in 6 figures will receive little by the way of need-based financial aid. Money in a 529 plan is treated as a parental asset on the federal financial aid form, and thus, only 5.8% is included in the calculation. None the less a 529 plan will reduce a student’s eligibility to participate in needs based financial aid.
Watch out, many college financial aid officers look at home equity as a potential source of your contribution. Thus, a long term strategy, keep your home mortgaged to the hilt, never pay down on it, do not keep the money from the home refinance in cash, stocks or other investments. Keep the refinance monies in an financial aid exempt investment.
One of the best long term strategies is to start early investing. As of 2007 the average cost of a state school (total expenses) is about $17,000/per year increasing 10-20% per year. The correct time to start college savings is when the child is born and you hear two sounds (slap and WAAH!)
At $17,000 per year, or $68,000 for 4 years of college today, using a 10% inflation rate, in 18 years that 4 years will cost $144,000. So, using a 10% average rate of return, how much needs to be saved for 18 years, starting at a child’s birth to accumulate the $144,000?… $263/per month starting the day the child is born. If you wait until the child is 5 years old to start, the payment is $489 per month. If you start when the child is 10 years old then the payment jumps to $1049 per month.
As I have stated many times in this column the number one reason for financial failure is procrastination. Start early!