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Saving For College: Understanding 529s and Other Options

College costs have been rising by between 2% and 4% per year for three decades, according to the College Board. Although a lot can happen in 18 years, it’s hard to imagine that college will be significantly cheaper for our children than it was for us. So the sooner you can start saving for college, the better.

Even if your children are years away from moving into their dorms, your family should have a savings plan — ideally one that you are funding every month so it can grow for as long as possible. 

Saving for college using a 529

Many families save for college using 529 savings plans, which are typically sponsored by the state. Parents can pay into these savings plans throughout a child’s life, and then make withdrawals to cover qualified education expenses. 529 plan earnings grow tax free, and growth on distributions is only subject to federal income tax if they are not used for those qualified expenses.

Generally, qualified expenses include tuition, room and board costs, and educational materials including computer technology and equipment for both undergraduate and graduate degrees. As of 2017, you can use a 529 to pay for up to $10,000 per year in K-12 tuition as well. Note that not all states have conformed to this new change, so before you use the 529 for K-12 tuition, check your state’s rules or consult with a CPA. Expenses that do not qualify include sports or club activity fees, transportation costs, and repayment of student loans, among others.

Many states offer tax benefits for investing in 529s, including state income tax deductions and tax credits. But you can sign up for a 529 plan in any state, regardless of where you live or where you plan to pay tuition. So if you do not receive a state tax benefit, you can shop around for a plan with low-cost investment options. Some states even provide the state tax deduction benefit with any state 529, not just those of that state.

There are several types of plans under the 529 umbrella: College savings plans and prepaid tuition plans. College savings plans are most common. Parents or guardians invest after-tax contributions, the way you would fund a Roth IRA, and choose from several investment options based on their desired level of risk. This account can be used to fund educational expenses at any college or university. 

With prepaid tuition plans, parents or guardians pre-pay for educational costs at an in-state public college or university. These plans can be converted to fund tuition at private or out-of-state schools, although that typically comes with a fee. 

Several hundred private colleges also offer the Private College 529 Plan, which is a prepaid tuition plan that can be used for educational costs at participating institutions. 

How much should you be saving for college?

I typically suggest that clients pick a certain public or private school, look at the expected cost of attendance, and try to fund half that amount. 

I do not usually recommend funding more than half because, if you don’t use the 529 on qualified educational expenses, you’ll pay tax on the gains and a 10% penalty. That will probably wipe out the investment returns you’ve earned and more. 

If your child receives a scholarship or if grandparents or other family members want to support their education, you may end up with money left over in your 529. You can use that money to fund another child’s education as long as they are a beneficiary on the account. A beneficiary can also use it in the future for graduate or professional school. It is relatively easy to change the designated beneficiary on a 529 to another family member.

I encourage my clients to start funding 529s as soon as a child is born. Many 529s are organized like target-date retirement plans, in that the investment strategy is more aggressive when the child is younger and gets more conservative as they grow up. If parents make the recommended monthly contributions, plan administrators should take care of the rest.

Other types of college savings plans

Some parents save for college using UTMA/UGMA accounts. These custodial accounts — created under the Uniform Gifts to Minors Act and Uniform Transfer to Minors Act, hence the names — can hold assets for children until they reach the age of legal adulthood. The money in these accounts is considered the property of the child and will be taxed at the child’s tax rate. For children under 19, or full-time students up to age 24, who file as part of their parents’ tax return, that rate rises quickly: The first $1,050 in distributions are tax-free; the next $1,050 is taxed at the child’s rate; and the rest is taxed at the parents’ tax rate. 

Children with assets in UTMA/UGMA accounts are not obligated to send them on college. Further, custodial accounts are counted as assets when children apply for financial aid, which will usually result in them receiving less financial help.

The Coverdell ESA is a college savings account that looks much more like a 529. Parents, guardians or others can make after-tax contributions of up to $2,000 per year in the beneficiary’s name. They are often used to cover the costs of K-12 education, since 529s were not able to do so until recently, but they can also be used for college. 

Coverdell ESAs do have income limits, however: $95,000 for individuals and $190,000 for married couples. And if the beneficiary doesn’t use the savings by the time they turn 30, it can be rolled over to a Coverdell ESA for someone else, or the beneficiary can simply receive the money. 

If a parent or the child is the owner of the account, a Coverdell ESA may reduce the child’s financial aid award. If it belongs to another person, it will probably not be reported on the FAFSA and will probably not affect financial aid.

Understanding FAFSA

FAFSA is the Free Application for Federal Student Aid. The federal government uses FAFSA to determine which students are eligible for federal loans and awards like Pell Grants. Most colleges and universities require students to file a FAFSA to be eligible for scholarships or financial aid from the institution. 

College savings can reduce the amount of financial aid your child is eligible for, but each type of savings plan receives different treatment.

Parents are typically the owners on 529 plans, with the student as the beneficiary. In this case, if the amount of money in the plan exceeds a certain amount — usually around $20,000, depending on the parents’ age — financial aid reviewers will take the amount of money above that number and can reduce a student’s aid package by up to 5.64% of that excess amount. Typically 529 earnings are worth much more than that lost financial aid. 

Custodial accounts under UGMA/UTMA, however, are usually considered student-owned assets. These can reduce an aid package by up to 20% of the asset’s value, since the college expects the student to spend about 20% of those funds each year.  

For Coverdell ESAs, assets do not count against financial aid awards as long as the child is still a dependent. If a parent is the owner, Coverdell ESAs are treated like 529s; if the child is the owner, they’re treated like UGMA/UGMA custodial accounts.

In the meantime, you don’t have to wait for college to talk to your kids about money. Start these conversations while they’re young. Kids who see their parents problem-solving and learn about concepts like budgeting will be well equipped to grow into responsible spenders.

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