Overview: When saving for a child or grandchild’s college education, many individuals choose 529 college savings plans because of their tax advantages.
529 Plan Basics
A 529 plan is similar to a Roth IRA in that you contribute after-tax dollars that grow tax free. Earnings from the plan can be withdrawn free of federal taxes for qualified college expenses.
Each state has its own plan, but you are not required to use the 529 offered by your state of residence. You can open a 529 account in any state. However, this does not mean the student (beneficiary) must choose a college in the state where the 529 was established. For example, a plan owner can live in Illinois, open a 529 account in Missouri and use the account to pay for the expenses of a private college on the East Coast.
A 529 plan has an owner and a named beneficiary. Anyone can act as the owner of the plan. Likewise, anyone — child, grandchild or even the owner — can be named as beneficiary. The owner of the plan, not the beneficiary, retains control of the assets. Anyone can contribute to the plan, but only the owner can make withdrawals. If a child or grandchild is named beneficiary, the assets will not be treated as their personal assets for federal financial aid purposes.
Choosing an Appropriate Plan
With so many 529 plans to choose from, it is helpful to consider three factors: investment options, costs and tax benefits.
No matter what type of savings plan, it is good to understand your investment options. A suitable 529 plan should offer a wide variety of investments with both domestic and foreign investments. The plan should ultimately reflect your personal investment philosophy.
The lower the costs, the less returns will be reduced by fees. Low fees are important when choosing a plan. An example of a low fee is 0.25 percent per year, whereas 1.00 percent per year is an example of a rather high fee.
Both federal and state tax benefits should be considered. Choosing your own state’s plan should not be the default option. It is important to research and compare each state’s plan and tax benefits before selecting a 529.
Additional Steps to Finding an Appropriate Plan
It can also be helpful to take the following steps before making a decision:
Step 1: Consider your own state’s plan, particularly if the plan offers any state tax benefits for contributions. Ask the following questions when assessing your state’s plan.
Are the plan’s expenses reasonable?
If you move to a different state is the plan flexible?
How are the plan’s funds allocated?
You might find that you choose to rule out a 529 plan that meets all but one of the above requirements, even if it is your own state’s plan. For example, your state’s plan might offer state tax savings and be flexible but charge an excessive expense. The high expense might be a reason to examine other states. These questions are helpful when examining any 529 plan.
Step 2: Check that appropriate asset allocation is available within the 529 plan.
Generally, 529 plan assets should be invested more aggressively for younger beneficiaries and less aggressively for older ones. Look for age-based options within a 529 plan because such a plan would offer a strategy of investing college savings less aggressively as the beneficiary ages. The age-based option requires little maintenance because it correlates and adjusts the overall portfolio allocation with the beneficiary’s age. However, it is important for the owner to monitor the portfolio on a regular basis.
Alternatives to 529 Plans
Another option is a Coverdell Education Savings Account (ESA). Similar to a 529 plan, this savings account is designed to help parents and students save for education expenses including elementary school expenses. A main difference with this savings plan is that contributions to the account cannot exceed $2,000 in any year. To learn more about Coverdell, visit www.irs.gov.
Some investors prefer to take no risk when saving for their child or grandchild’s education. For those looking to avoid risk, a traditional savings account is a good alternative.
Another option would be to contribute to both a traditional savings account designated for college savings and a 529 plan, much like diversifying retirement savings by contributing to both a traditional 401(k) and a Roth 401(k).
Paying for college is not an easy feat, but 529 plans can help alleviate some of the financial burden.
When it comes to 529 plans, there is a great deal to understand and consider. To review 529s and find out the different tax benefits and fees of each state’s plan, visit www.savingforcollege.com.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm. Copyright © 2012, Buckingham Family of Financial Services.