Taking control over your money is a complicated task especially when the "discretionary" money is not a lot to distribute. However, regardless of how much you have, if you have pre-college age or even already college age children, now is a good time to look into saving for college in a 529 plan.
What is a 529 Plan?
Named after the provision of the IRS code that deals with taxes on the income from such plans, 529 plans allow you to invest after-tax dollars to pay for qualified educational expenses for whatever beneficiary you designate. Such expenses range from tuition, room and board, fees, books, etc. The money from the account grows tax-free until you are ready to use it.
Why are they a benefit?
First of all, the money you invest in such plans grows tax-free as long as it is used for qualified educational expenses. So, if your children are young, and you are investing for a while, you can get significant gains in the accounts without paying any taxes on those gains. That did not entice so many people in the past because the favored tax status was set to expire in 2010. Now, however, that tax status is permanent. Therefore, if you invest money and it grows, you will get to withdraw that money without paying any taxes on the earnings. In and of itself, that is a fairly significant benefit because the same money in a regular account would be taxed at anywhere from 15% for the capital gains and dividends to your own income tax rate, if, for some reason, it is not in a favored tax account.
Secondly, for those of you who may be eligible for financial aid, such accounts are considered the property of the account holder and not the beneficiary. Other vehicles used for college savings, such as the Uniform Gift to Minors Act accounts, are considered assets of the minor whose name they are under. When you apply for financial aid, only 5% of the parents' assets are considered as eligible for college payments, whereas 35% of the student's assets are considered eligible. Thus, if you had $100,000.00 saved in your child's name, federal financial aid formulas would consider $35,000.00 of it as available to pay college expenses; if that same money is in a 529 account, only $5,000 of it will be eligible for college expenses under current aid formulas.
Third, you may get a state tax write-off for investing in 529 accounts either directly through your home-state's accounts or, at least in Pennsylvania, if you invest in an account even through other states. Not all states offer the tax break and some have limits on the amount that can be deducted. If, however, your state offers the tax break, then, there is no reason not to contribute to a 529 account even if all you do is park the money there until you have to spend it on the college expenses. That is why the accounts are useful even if your children are already of college age.
For example, let's say I set up an account, in New York, for my 19 year old son who is already in college. I can get a New York deduction for all amounts I contribute up to $10,000.00 (if married, $5,000 if single). Even if I contribute the full amount, I can take it right out to pay for qualified expenses and still get the tax write off.
Moreover, the accounts have fairly generous allowances for total contributions. Thus, the maximum amount that can be contributed in New York is $235,000.00. That means that you can invest $235,000.00 in tax-free accounts that you can use for qualified educational expenses. If you have small children you may not believe me; however, college costs are extraordinary -- they can easily exceed $100,000.00 per child especially in private schools. And if one child does not use the whole amount, it can be transferred to another person in the same family.
What is the downside?
The most dangerous part of such plans is the same as with any investment: your investment is not insured and you could lose it if there is a downturn in the investment vehicle you choose. In addition, if your state does not have a good plan, you might also have very high expenses especially for managed plans. In New York, the expense ratio of a direct plan is .055% of the assets which is more than I pay for my retirement funds, but still somewhat reasonable. However, plans sold through brokers and financial advisors, rather than bought directly through your state, can have much higher expense ratios.
Some people also do not like the options offered in such plans for investment. New York's plan has basic options that allow you to be more or less conservative in your investment choices or let you automatically invest depending on the age of the child. Each plan is different in terms of expense ratios and options for investment.
The last downside is that you may pay a penalty if you do not use the money for qualified educational expenses. Thus, if you take the money out of the account and you do not have tuition bills or other costs that equal what you took out, you will pay a 10% penalty on the earnings as well as the back taxes. You will also have to pay back your state for any deductions you have. Thus, you should only invest in such plans if some or all of your children are going to college.
How do you find the right plan?
First, check your own state. If your state offers a plan, it will explain the tax implications of its plan as well as whether or not there is a benefit to owning your own state's plan. It will also explain the expenses. If your state does not give you a tax write off, you can compare plans; however, several articles I have read on the subject indicate that Utah has the best plans: I have not researched Utah's plan specifically because my state, New York, has a good plan with a tax deduction for state taxes.
If your state gives you the write off, go for it right away. Be sure to check the following: the maximum contribution allowed per beneficiary, the maximum tax deduction, the investment choices, and the expense ratio. This could be just the motivation you need to begin saving for your children's future.
It may also make sense to cash in any bonds you have for your kids and put the money into this plan instead -- look into the numbers, you may find that you will earn more in this kind of plan and you will not pay taxes.
Finally, even if it is only a small amount every week, the sooner you save for college, the better off you will be -- my husband and I have learned that the hard way -- with not a lot for college, we are borrowing to fund a good deal of my son's college; we will have to pay off that debt before we can even think about retiring. If we had socked away some of the money we blew, we could have it much easier now. But, no guilt: better late than never and my new knowledge is allowing me to save some money on my state taxes this year. Hooray for me.
It Makes a Great Gift Too:
If Grandma and Grandpa want, they can also set up 529 plans for their grandchildren. They might get a tax break and help pay for college. And if they don't want to set up their own plans, and they do give a gift of money, you can add that to the 529 plan and let it grow tax free. And if you are a grandma or grandpa, you can give your own grandchildren the gift of college with these sorts of accounts. (Just make sure you give them a little something to open too).