There are many ways to save for your children’s college education. It’s easy to find information on the various offerings online. I focus on 529 plans, which have become the most popular savings mechanisms specifically focused on education.
A 529 plan is a tax-advantaged investment program designed to facilitate savings for education expenses. 529 Plans are formally known as “Qualified Tuition Programs.” Plans are administered at the state level and come in two forms: prepaid tuition and college savings plans.
According to the CollegeSavings.org website, 529 Prepaid Tuition Plans (sometimes called guaranteed savings plans) allow participants to pre-purchase future tuition at a predetermined rate today for a specific state college system. Typically, an account owner will purchase somewhere between one and four years of tuition for a young child. When that child reaches college age, the plan pays out based on tuition rates at that time. If your child does not attend that college system, or does not attend college at all, you may not receive the full credit value.
529 College Savings Plans are different in that your child’s account accumulation is directly based on the market performance of underlying investments chosen by you from a menu of mutual funds. Investment choices tend to be limited to a small set of funds. These are directly managed by the state or an investment manager contracted by the state.
Most 529 savings plans offer age-based investment options. Their underlying investments become more conservative as the beneficiary gets closer to college-age. More specifically, their asset mix changes over time from a heavier weighting on stocks to a heavier weighting on less volatile securities—namely bonds. They also offer static investment options where the underlying investments remain in the same fund or combination of funds until you change them.
By law, you’re allowed to make changes to your existing investments in a 529 account up to twice per calendar year. This applies to transferring money from one investment portfolio to another. For example, from an all-equity fund to a money market fund. There are ongoing efforts to increase this frequency (automatic changes within age-based portfolios don’t count). You can change the investment options for future contributions anytime.
You can choose to invest in your state’s plan, or in a plan offered by another state. The CollegeSavings.org site allows you to compare plans.
Qualified Uses and Tax-Related Benefits
Money in a 529 college savings plan grows tax-deferred. The money may be withdrawn tax-free when used for qualified education expenses, including: tuition, mandatory fees, room and board, books, school supplies, and required equipment, as long as it is legitimately used for education purposes. A computer used primarily to complete schoolwork qualifies, but a video game on the computer would not. The 2018 Tax Cuts and Jobs Act (TCJA) extended the use of 529 distributions to cover elementary and secondary school tuition. The 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act includes allowances for student loan repayment using 529 funds.
Keep receipts for all tuition, room and board, and other education-related purchases. Avoid mixing eligible and ineligible items on the same receipt as this can lead to confusion and reporting errors. While a third party administers your 529 plan, you are responsible for correct IRS filings.
Many states offer additional tax deductions, credits, or other benefits to residents enrolled in their own state’s program. The tax deductions are available to the account owner, who is typically a parent or grandparent. Multiple adults can open up 529 accounts for the same child.
Payments into 529 plans are considered gifts, subject to the allowable annual gift tax exclusion which is set at $15,000 per individual in 2019. Contributors can contribute as much as $75,000 in a single year (known as “superfunding”) as long as they don’t contribute anything else over the next four years. In effect, they take advantage of five years of the gift tax exclusion in expedited fashion.
What If My Child Doesn’t Go to College?
The plan beneficiary may be changed to any of a number of eligible family members. These include: another child or stepchild, a first cousin, niece or nephew, grandchildren, as well as the spouses of all eligible family members.
If there’s no alternative beneficiary and you wish to gain access to the funds for non-educational purposes, you can withdraw them from the 529. But you must pay state and federal taxes, plus a 10% federal penalty on any earnings withdrawn. Your original contributions are made after tax, so they’re generally not subject to these taxes and penalties.
What If My Child Gets a Scholarship?
Funds in the plan could be applied to any other eligible education expenses not covered by the scholarship. Unused earnings withdrawn from the plan would be subject to taxation at the scholarship winner’s tax rate but the 10% penalty may not apply.
Early in your career, when your salary is low, it may be difficult to make ends meet: that is, cover the mortgage, max out retirement plan contributions, make loan payments, pay for disability and life insurance policies, or satisfy any other cash-draining needs.
If you find yourself in such circumstances, consider not contributing to a 529 plan until your budget allows (once expenditures decline or your income increases). This does not make you a bad parent. It makes you a responsible financial planner. Stabilizing your finances first and safeguarding the household’s needs will put you in a much better financial position overall, thereby allowing you to help your children down the road.
The highest priority is to provide your children with a loving home in a financially stable environment. If you opt to fund their education at the expense of your financial and mental stability you’ll only burden them later in life when they have to take care of you. If this argument doesn’t allay your feelings of guilt I make a more scientific pitch for such prioritization in the retirement planning chapter.