If you are like most parents, providing best opportunities for your children is undoubtedly foremost on your mind. Your saving for children plan should include saving for college. There are many options available today in the United States. In this article, we will take a look at 529 college savings plan. As we will find, a 529 college plan not only offers a great way to save college funds for your child’s education, but it also makes for a great estate planning vehicle.
If you are expecting birth of a new child, first of all, Congratulations! You are in for a possibly large increase in your monthly expenses. You can get a jump start on college savings by cutting new child expenses to free up monies to save.
Tuition costs continue to rise
College education is expensive and becoming more so. Average college tuition in United States has been rising by an average of 6% per year, whereas the long term inflation rate averages around 3%. Tuition at some of the best private colleges are rising even faster. If your child has 16 more years before she enters college (which means you have started planning reasonably early compared to the average population), at a 6% rate of tuition inflation, the 4 year college program that costs $30,000 per year today will cost $333,393 over the four year program. This, along with the fact that an average American family has a little more than 2 kids on average, and it is not difficult to see a good college education quickly becoming unaffordable for many families. Partly in response to the rising tuition cost, many non traditional schools such as south university are coming up as an option offering flexible schedules and allowing students to work full time to afford the cost. But these should be a fallback option at best.
Many college savings options available today suffer from one or more drawbacks. If you plan to save for college in a taxable account, than income taxes on dividends and capital gains will reduce your ultimate return on investment. If you decide to move your taxable savings to your kids names to reduce taxes, than you will need to worry about lack of control over how these savings are managed at some point in the future and may cause a few other Estate Planning headaches. Other tax advantaged savings options for Education may limit your contributions resulting in under savings. You will also need to worry about how these savings will impact your children’s eligibility for financial aid if you would like to consider that as an option.
A section 529 College Plan overcomes many of these constraints and can provide best of all the worlds.
How does a 529 Plan work?
Section 529 of the Internal Revenue Code created these types of savings plan in 1996. Currently all states offer some form of 529 college plan. These plans work similar to a 401K plan in that every plan has a range of investment options that one can choose to invest in. In most plans, these options are in form of a mutual fund or a vehicle similar to a mutual fund.
At this time it is important to make a distinction between a 529 College Plan and a 529 Prepaid Plan. A 529 Prepaid Plan can be offered by a state or an educational institution and limits the benefits to a selected group of colleges and universities. Essentially, in these plans, you are prepaying the future tuition in current dollars. 529 Prepaid Plans therefore are not as flexible.
They offer lot of choices
You are not forced to invest in your own state’s 529 College Plan. You can pick and choose any other state’s 529 plan based on your investment criteria, fees, options, etc. Additionally, a large number of colleges and universities across the US and even some internationally are eligible institutions where 529 plan benefits can be applied. 529 College Plan generally do not have restrictions forcing the beneficiary to use an in-state institution.
Gains on investments in a 529 College Plan are sheltered from all taxation as long as the proceeds are used for tuition and other allowed educational expenses at an eligible institution. Additionally, some states encourage their own residents to participate in the state offered 529 College Plan by offering tax incentives like tax deductions on part of the contributions to the plan.
529 Plan offers high contribution limits
Most 529 College Plan do not have a contribution limit per se, although they limit further contributions when the assets reach a certain size (typically in the neighborhood of $200K per account, limits vary by plan). It therefore makes sense to contribute to these plans more aggressively in the initial years and reach the asset size limit as quickly as possible. This will allow the account to grow with a higher base for a longer time. This becomes very important when you realize that as the time to college comes near, you are very likely to change your asset allocation in the plan towards more conservative investments and therefore maximum asset growth is likely to occur in the initial few years of the account.
There are however certain other limits to contributions that you need to be aware of. Contributions to a 529 College Plan are treated as a gift from you to your child (the beneficiary on the account). Therefore they may come under the purview of Gift Taxes. To avoid paying gift tax on the contributions, you should plan to keep the annual contribution per beneficiary to be below the gift tax exemption amount, which is currently at $13,000 for 2009. You and your spouse can there fore contribute upto 2x$13,000 or $26,000 annually to each child’s 529 College Savings Account without having to worry about gift tax.
529 Plan assets have small impact on Financial Aid eligibility
A 529 College Plan held by a parent for the benefit of the child is considered a parental asset and will be assessed at a maximum rate of 5.64% in determining a student’s expected family contribution. Additionally, any tax free distribution of the plan to pay for education costs for the beneficiary in the current tuition year will not reduce next year’s financial aid eligibility as it is not considered as part of the base-year income.
There are no income limits
Unlike Education IRAs where your eligibility to contribute gets phased out based on your income, 529 College Plans do not have any such income limits. Therefore, these plans are available to everyone.
A 529 College Plan should be a critical component of your estate plan
One of the great attractions of 529 College Plans is its use in Estate Planning. Contributions to the plan are considered as gifts and therefore are no longer part of your estate. You also have the option of accelerating the transfer of assets out of your estate by contributing next 5 years worth of contributions in a single year. Which means, you can potentially transfer $13,000 x 5 = $65,000 out of your estate to your child’s 529 College Plan this year if you so choose without having to worry about gift taxes. Your spouse can do the same as well for a total of $130,000 per child. However, if you choose to utilize the 5 year prepayment option to the plan, you will not be able to make any additional contributions to the plan for the next 5 years. But still, the ability to transfer significant amount of assets out of your estate is a very attractive feature.
You still retain control
If you are the owner of the account for the benefit of your child, even though the account assets are no longer part of your assets, you retain the full control of the assets. Your child never gets control of the assets at any age. You also have the flexibility to change the beneficiary of the account if you so choose, even to yourself or your grand children. This flexibility is useful in case your child does not end up using all the assets for his/her education, or even decides to drop out of college. The only caveat is that the distributions are only tax free if used for eligible education expenses.
For more information on 529 plans and to evaluate different plans and choose the one you want to participate in, please visit the excellent Saving for College website. This website features many different types of calculators as well as community message boards and is a very useful resource for anyone trying to choose a 529 College Plan for their child.
Are you contributing to a 529 plan or trying to decide on one? Which state plan did you choose and why? Feel free to add to the discussion by commenting to this article.