Many parents worry about the rising cost of college. That’s why Congress created college savings plans, also known as 529 plans, after Section 529 of the Internal Revenue Code. The owner of the plan – usually a parent, but sometimes a grandparent, godparent or even the child him or herself – invests post-tax dollars. Funds grow tax-free until the student enters college. As long as they spend the money on tuition and qualified school expenses, withdrawals aren’t taxed.
Every state offers some type of 529 plan, and investors are free to purchase a plan from any state. Many educational institutions offer 529s directly to consumers. Plans fall into two types: college savings plans and prepaid tuition. Students can spend the dollars in their college savings plan at the school of their choice. Prepaid tuition, on the other hand, locks the student into attending a particular college.
Tuition Plans versus a College Savings Plan
For parents, the challenges of 529s include knowing whether the plan will benefit their situation, when to open the plan and which type to pick. Alexis Hongamen, a chartered retirement planning counselor, suggests opening a 529 as soon as you’re sure your child is collegebound. “If you know for a fact that the student will attend a public school in the state of Virginia, with very little chance of them selecting an out-of-state institution, the prepaid tuition may be more appealing.” Prepaid plans lock in the tuition price, while college savings plans are subject to market fluctuations. State plans are often guaranteed by the state.
Of course, many children won’t appreciate their parents picking a future school for them. College savings plans offer greater freedom, but more risk. However, in addition to tuition, funds can be used for room and board, mandatory fees, and required books and computers.
529s and FAFSA
Things get tricky when parents factor in how 529s will affect financial aid. As the Securities and Exchange Commission’s website puts it, “while each educational institution may treat assets held in a 529 plan differently, investing in a 529 plan will generally reduce a student’s eligibility to participate in need-based financial aid.”
A plan owned by the parent is more strategic than one owned by the student, as a maximum of 5.64 percent of parental assets count toward the scholar’s expected family contribution.
Charlie Donaldson, president of College Bound Coaching, advises parents to weigh their expected need for financial aid before opening a 529. “For every $10,000 of value in a 529 plan, the student could lose $564 per year of free money from the colleges,” he says. However, this won’t impact higher-income families and those students applying to schools that aren’t generous with financial aid.
Risks and Benefits
In the best case scenario, a 529 plan quietly builds until it’s time for the student to leave for college. However, there are risks. “There are penalties and tax to pay if the person that opened the 529 plan for a loved one changes their mind and wants the money back,” says Hongamen. “The same applies if the loved one changes their mind and decides not to go to college.” However, parents can change the beneficiary to a sibling.
For parents of college-bound children, 529 plans are worth investigating. Talk to your financial advisor to find out if one fits your personal situation.
