529, What?!

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Opening up a college savings account has been on my list of things to do…for years. About 5 years to be exact, the age of my oldest daughter. The problem is that raising small children and researching college savings plans are not very compatible activities. Every time I’d start to do a little homework to figure out what a 529 was, I wouldn’t get deep enough before I’d get interrupted by a toddler waking up or by an emergency after-hours work email.

At last I’ve finally had the time to dig in and do enough research to feel confident in how to proceed. When it comes to doing research, I love getting into the details but I have limited this post to just the highlights of what I learned. This is a fairly meaty topic and everyone’s situation is going to be slightly different, so if you want to go deeper I’ve listed my sources on the ‘Resources’ page of this blog.

My ultimate decision was to set up an automatic monthly withdrawal to target funding 50% of a public school education through the Nevada 529 Plan for each of my children. I’m planning to revisit that decision periodically since my financial circumstances and the regulatory environment can always change. My thinking is that I’ll fund the rest of the kids’ tuition through my regular investment accounts.

For what it’s worth, I also considered contributing to a Private College Prepaid 529 which can be transferred to a regular 529 if my kids don’t attend one of the participating colleges and a Coverdell Education Savings account which can be used to invest like a self-directed IRA. In the interest of not hitting analysis paralysis, for now I’m keeping it simple with just the 529 Plan.

Below are highlights of what I learned to arrive at that decision, based on the questions that were top of mind for me.

Q: What are the ways I can save for college?

There are many possible ways to pay for a college education. Here’s a list I compiled of some of the more popular savings vehicles, along with the pros and cons of each. The option that was by far the most frequently mentioned was a 529 plan, so I shared a little more detail on that one below this chart. If you want to do a detailed comparison, savingforcollege.com offers a great tool to see a comparison of college savings options.

Plan Description Pros Cons
529 Plan Tax-advantaged savings account authorized by Section 529 of the Internal Revenue Code, specifically for qualified post-secondary education costs
  • Earnings grow tax-deferred and distributions are tax-free when used for qualified post-secondary education costs
  • Can deduct contributions from income taxes in some states (sadly not California)
  • With few exceptions, the named beneficiary has no legal rights to the funds
  • Can change account beneficiaries, so if you don’t use the money for one child, you can use it for another member of the beneficiary’s family
  • 10% penalty when distributions aren’t used for qualified expenses
  • Considered a parental asset on the FAFSA which will reduce a student's aid package by a maximum of 5.64% of the asset's value
  • Limited investment options, some plans carry high fees which can significantly cut into your earnings
Prepaid 529 Plan A plan that lets you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges.
  • College costs have been skyrocketing recently so this program allows you to lock-in today’s rates, making the rate of return on the investment equals the rate of tuition increase
  • Participation is often restricted and a limited number of states offer them
  • Geared toward in-state public institutionsYour principal plus earnings may not cover tuition and fees if the student decides to attend a private or out-of-state college or university
  • Pulling out of a prepaid tuition plan can result in stiff penalties
  • Narrow definition of college expenses
Coverdell Education Savings account A tax deferred account dedicated to saving for education expenses (both college and K-12 expenses)
  • Earnings grow tax-deferred and distributions are tax-free when used for qualified education expenses
  • Investment options aren’t as limited as 529 plans - you can self-direct investments, much like a self-directed IRA
  • $2000 annual contribution limit. If total contributions exceed $2,000 in a year, a penalty will be owed10% penalty when distributions aren’t used for qualified expenses
  • Considered a parental asset on the FAFSA which will reduce a student's aid package by a maximum of 5.64% of the asset's value
  • Contributors have income limits, but children (whose income would be below those thresholds can be contributors)
  • Distributions from an ESA are always paid to the beneficiary and cannot come back to parent
UTMA/UGMA Accounts (Uniform Transfer to Minors / Uniform Gifts to Minors) Custodial accounts that allow you to save on behalf of a child for education (or any other purpose that benefits the child) until they reach the age of majority in their state
  • Because the assets are considered the property of the minor, these accounts are often used to take advantage of the “kiddie tax.” The kiddie tax allows a certain amount of a minor’s income to go untaxed, and an equal amount to be taxed at the child’s tax rate (as opposed to mom and dad’s rate)
  • There is no penalty if account assets aren't used for college
  • Contributions are irrevocable and you can’t change beneficiaries
  • Upon reaching the age of majority, the beneficiary can use the assets for any purpose—educational or otherwise
  • There is a significant impact on federal financial aid. The account is treated as the child's asset and weighed more heavily in financial aid calculations
  • Contributions aren't tax-deductible and earnings are subject to federal income or capital gains tax
US Savings Bonds EE and I bonds purchased after 1989 by someone at least 24 years old may be redeemed tax-free when the bond owners, their spouses, or dependents pay for college tuition and fees
  • Interest earned may be exempt from federal income tax if bond proceeds are used to pay the beneficiary's qualified education expenses, provided certain other conditions are met
  • Bonds are backed by the federal government, hopefully the rate you'll earn is guaranteed
  • You retain control of the bonds as long as they are owned in your name
  • Bond proceeds not used for the beneficiary's qualified higher education expenses will be taxed
  • Income must be below a certain level at the time you redeem the bonds for you to be eligible to exclude the interest earned from federal income tax (yet you must add bond proceeds into your total income for the year when determining whether you meet this income threshold). In 2014, the tax exclusion is phased out for incomes between $76,000 and $91,000 (between $113,950 and $143,950 for married taxpayers filing jointly)

Note, there are other ways you could conceivably fund your child’s college education. Some people do it through their IRA or insurance policies. I didn’t see any huge benefit to doing this and these options seemed pretty complicated and possibly risky.

More detail about 529 Plans…

Because 529s are so popular and because that’s the option I decided to pursue, here are some more detailed notes about their advantages and disadvantages:

529 Details: Advantages

There are significant tax benefits. The biggest benefit is that earnings are tax-deferred. You invest in a 529 plan with after-tax money but you don’t pay capital gains on the appreciation of your 529 account when the money is withdrawn. All money inside the account grows tax free and distributions made to pay for education expenses are not taxed. So it works like a Roth IRA. Also, some states allow you to deduct contributions from your taxes, though sadly my home state is not one of them.

It’s basically a pool of money, controlled by the account holder, that you can target to any family member for education expenses. You need to set up the account for a specific beneficiary, but if that person doesn’t use all of the funds, you can change the beneficiary to another family member, like a sibling or a parent. Also the account holder maintains control of the funds, not the beneficiary. There’s a $14,000 annual contribution limit – the federal gift tax limit – though there seem to be a few exceptions to that if you’re trying to catch-up on contributions.

It’s an easy way to make sure you’re saving for college. Once you set up the automatic withdrawals, you can passively monitor the account.

529 Details: Disadvantages

Investing in a 529 limits how you can allocate those funds in the future. When a withdrawal is taken but is not used for “qualified higher education expenses,” the earnings may be subject to income tax plus a 10% penalty tax. A few people have also pointed out that students can get a loan to pay for school but parents can’t get a loan to pay for retirement. For this reason, I decided to target paying for a portion of my children’s projected education expenses and plan to pay for the rest from other savings.

There’s a possible reduction in the beneficiary’s ability to receive financial aid.However, I’ve read that when it comes to financial aid, these plans are treated very favorably. They are owned by a parent, so they are assessed at just the 5.64% parental asset rate for the expected family contribution (EFC), and the distributions are not counted as base year income on the FAFSA.

Investment options are limited and you need to watch the fees. Apparently fees have been coming down recently and it’s easy to compare fees on sites like savingforcollege.com to find a low cost plan.

Q: How should I think about the tradeoff between saving for retirement and saving for college? How much should I plan to set aside for college?

The best advice I’ve seen on how to make this decision is to err towards funding your retirement because you can apply for financial aid to pay for college but there are no financial aid packages for retirement. You don’t want to support your kid’s college education, but burden them later with elder care costs.

Many experts advise taking full advantage of retirement accounts like 401(k)s and IRAs before you start funding college savings, especially if you have employer matching.  Assets in retirement accounts will not affect your child’s prospects for federal financial aid (unless you actually take distributions from them during the college years).

To figure out specifically how much to set aside, I used a combination of of online calculators, like the one on savingforcollege.com, and the ‘Options Viewer’ tool I built to explore future wealth scenarios and land on a number.

Q: There are so many 529 options, which one do I pick?

I looked for a plan with low fees and an adequate number of investment fund choices. Ultimately I narrowed down the search to states that had Vanguard funds and then compared the details of those plans on savingforcollege.com. I looked in particular at Nevada, Utah and New York. New York’s plan description made it seem challenging to transfer assets into another state’s 529 plan if that ever became necessary so I steered away for that reason. Ultimately I liked that Nevada was fully supported by Vanguard customer service whereas Utah was not.