Eric Sachetta
Considering the projected costs of a college education over the next few decades, it could cost more than a million dollars for your kids or grandkids to get a degree someday. Naturally, saving for college is a top concern for parents and grandparents today. But it’s challenging to figure out which savings strategy will yield the best return and meet your family’s specific needs.
Many people assume that a 529 college savings plan is the ideal vehicle for college saving, and these plans can be a great fit for a lot of families. They’re not the only choice, though. There are some disadvantages to 529 plans that could make other college savings strategies a better fit in some circumstances. Your financial and investment advisors can help you analyze your choices and craft the ideal college savings strategy for your family.
HOW DO 529 COLLEGE SAVINGS PLANS WORK?
Each state sponsors 529 college savings plans, though most 529 plans don’t have state residency requirements. For example, grandparents could open a 529 plan in Massachusetts for a child who lives in New York, and family members anywhere in the U.S. could contribute. A beneficiary may have multiple 529 plans in their name. Anyone can open and/or make contributions to a 529 account, and any U.S. resident can be the beneficiary. The beneficiary can withdraw 529 plan funds tax-free to pay for qualified educational expenses.
PROS OF 529 COLLEGE SAVINGS PLANS
- Beneficiaries can use 529 funds for more than just college. Qualified educational expenses include elementary through high school tuition costs as well as college and post-graduate study. Money in a 529 plan can be used to pay for things like vocational school, certifications, continuing education and even some study abroad expenses.
- Contributions are (generally) tax deductible. At least some of the money you invest in an in-state 529 college savings plan is deductible from your state tax return (in most places). Massachusetts residents can deduct up to $2,000 in 529 contributions from state income taxes. However, making out-of-state 529 contributions does require tax planning, as these contributions typically aren’t deductible. To continue the above example, grandparents who are Massachusetts residents are eligible for annual deductions of up to $2,000 for contributions to Massachusetts U.Fund accounts. But if they contribute to a 529 plan that the child’s parents open in New York, they get no tax benefit.
- No contribution limits means you can save as much in a 529 plan as you’re able. The only caveat is that contributions to a 529 plan are considered gifts for tax purposes. Large contributions exceeding your annual gift tax exclusion amount will trigger gift tax—unless you elect to “superfund” the account. Superfunding is a one-time benefit that allows you to put up to five years’ of your annual gift tax exclusion amount into a 529 without paying gift tax.
- 529 funds are safe from contributors’ creditors. In the event that a beneficiary’s parents or other 529 contributors declare bankruptcy or have creditors collecting on debts, any money they’ve put into a 529 plan should be safe.
CONS OF 529 COLLEGE SAVINGS PLANS
- 529 plans have somewhat limited investment options. If you have strong preferences for how the money you’re saving is invested, 529 plans aren’t ideal. Financial institutions that administer 529 plans typically offer a limited menu of investment types for account owners to choose from.
- Beneficiaries are penalized if they don’t use 529 funds for qualified expenses. What happens if you put aside tuition money in a 529 college savings plan, but your child doesn’t use the funds because they pursue a career path that doesn’t include college or any kind of higher education? You could change the beneficiary of the account to someone else who will have educational expenses. Or, you (as the account owner) can withdraw the money from the 529 college savings plan, but will pay a 10 percent penalty plus federal income tax on the cash.
- There are withdrawal limits for pre-college expenses. If your child or grandchild goes to a private school for elementary, middle or high school, only $10,000 per year can be withdrawn from their 529 account for tuition. At the college level, 529 accounts can be used for a broader range of qualified expenses including room and board, books, computers and software.
- 529 plans can affect financial aid. When a minor student fills out a FAFSA application for federal student aid, they have to report any 529 plans owned by their parents as parental assets. The impact of parents’ assets is minimal compared to the student’s income and the parents’ income. Still, parents owning a 529 plan is one of the factors that’s considered when federal financial aid decisions are made.
ALTERNATIVES TO 529 COLLEGE SAVINGS PLANS
The only way to determine the best college savings strategy for you and your family is to consult a financial advisor you trust. Here’s a brief look at two of the most common alternatives to 529 plans.
- Roth IRAs: Though typically used as a retirement savings vehicle, Roth IRAs can also be used to save for college and other educational expenses. Like 529 plans, contributions are made with after-tax dollars and qualified withdrawals are tax-free. Penalty-free withdrawals for qualified college expenses can be taken at any time and at any age. Roth IRAs provide a wider range of investment options compared to 529 plans. If the beneficiary doesn’t go to college, you can simply keep the Roth IRA for retirement. But there are a few drawbacks. Roth IRAs have income limits so they’re not an option for high-income families. They also have annual contribution limits, so there’s a cap on how much you can save for college this way. Funding a Roth IRA for college expenses also limits how much you’re able to contribute to your own retirement IRA in a given year.
- Coverdell Education Savings Accounts: Coverdell ESAs share many features with both 529 plans and Roth IRAs, but they have even lower income limits than Roth IRAs. ESAs also have contribution limits of just $2,000 per child per year. Overall, 529 plans are a better fit for many families' needs—but it’s also possible to contribute to both types of plans if you and your advisors determine that’s the best strategy.
HAVE QUESTIONS ABOUT SAVING FOR COLLEGE?
You’re not alone when you’re making college savings plans for the children you love. Sachetta’s investment advisors can help you understand your options and create a strategy that’s both tax-advantaged for you and ideal for your family’s circumstances. Talk to us about 529 college savings plans, Roth IRAs, ESAs and college savings questions in general. We want to help you make the investment decisions now that will help the kids you love reach their greatest potential down the road. Contact us today.
Eric Sachetta, ChFC®, CFP®, is a Certified Financial Planner™ practitioner and focuses on financial planning and client relationship management. Eric believes that estate planning provides an opportunity to “look at all things that you value, see how they fit together, and make choices to balance everything and to maximize the things you want to do.”