Like saving for retirement, you can never start too early on college savings. The cost of post-secondary education continues to outpace inflation, typically at a ratio of 2:1. According to FinAid.org, the historical average college tuition inflation rate was 8%. More recently, tuition inflation rates hover around 6% annually.
Relying entirely on student loans or merit-based aid to fund college isn’t wise, either. I’m going to debunk some myths related to college savings and offer strategies for getting started.
First Things First
According to this CNBC article, Fidelity has a new 2K rule of thumb: If you intend to cover ½ the cost of college tuition at a 4-year public university, multiply your child’s age by $2,000. Aim to have at least that much set aside in college savings. Using this example, a 10-year old should have $20,000 in the 529 plan account. Obviously, if you intend to send your child to a more expensive school or cover more than ½ the cost, the target amount should be higher.
The College Board’s 2014 study “Trends in College Pricing” indicates the average cost of a public college was $19k and private was $42k in the 2014-2015 school year. By 2024, those averages are expected to be $34k and $76k, respectively.
Many of my clients ask a similar question: how should our savings be directed? When there are so many competing priorities – emergency fund, paying off debt, saving for retirement, etc. – adding education savings to the list may seem too daunting. Generally, I encourage young families to focus on immediate goals like the emergency fund and debt management. We also look at maximizing any employer match through a company-sponsored retirement plan. THEN, and only THEN, do we explore 529 plan funding.
Two Types of 529 Plans
In the world of 529 plans, there are two primary types: Prepaid and Savings.
Prepaid plans are only available in select states and allow you to purchase tuition credits at today’s rates. Since these prepaid plans are administered by the state or higher education institution, investment performance is tied to tuition inflation. I
The more common 529 Savings Plans are available nationwide and are further subdivided into broker and direct plans. Broker-sold plans can be purchased through an investment advisor and are professionally managed by that advisor, while direct plans are generally less expensive but more of the “DIY” version. You, as the account owner, decide how to allocate investments in direct plans. Many of these state-run savings plans offer age-based options that gradually become more conservative as the beneficiary ages. The market performance of any 529 Savings plan is tied to the underlying investment.
Debunking the Myths
Now that you have a feel for the types of 529 plans, let’s play a game of true or false.
1. You must invest in the 529 plan of your home state. FALSE
Several states offer a state income tax deduction if you invest in your home state plan, but some states provide tax parity whereby you receive the state income tax deduction even if you contribute to an outside state’s plan. Examples of these parity states include: Arizona, Kansas, Missouri, and Pennsylvania.
2. You will lose money if your child (the beneficiary) doesn’t go to college. FALSE
The amount you initially contribute to a 529 plan can be withdrawn without penalty. Only the “gain” or appreciation is subject to income tax and 10% penalty for non-qualified (“NQ”) distributions. Let’s suppose you contributed $50,000 to a 529 plan and the balance grew to $60,000. You only pay income tax and 10% penalty on the $10,000 gain of NQ distributions. Furthermore, if your son or daughter will not be attending college, you can transfer 529 funds to another family member without penalty. There is no age or income limit for a beneficiary.
3. A 529 plan is a tax-advantaged investment that allows you to save for future higher education costs. TRUE
Contributions to 529 plans grow tax-deferred, and qualified distributions are tax-free. By definition, qualified 529 plan withdrawals include tuition, fees, books, equipment and supplies. Room and board is also considered “qualified” if the student is enrolled at least half-time at a university or vocational school.
4. Many 529 plans allow out-of-state investors, but benefits may apply to investors who participate in their state-sponsored plans. TRUE
Choosing your home state plan may result in matching grants and scholarships, protection from creditors, and exemption from state financial aid calculations. If you reside in a parity state, lower fees and superior historical investment performance may entice you to choose an out-of-state plan. Regardless of which state plan you choose, there is a downside: 529 plan balances impact the federal student aid calculation for need-based aid and reduce eligibility for select federal tax credits.
I personally believe the benefits of 529 plans outweigh any disadvantages. Please post any follow-up questions in the comments section below or check out SavingforCollege.com. No questions? Share this article with a friend who could benefit from it.
Deb Meyer, CPA, CFP®