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Sep-30th-2014

College 529 Savings Plans

411on5291The cost of college has increased dramatically over the past 10-20 years. The annual cost of many private colleges and some public universities is now $50,000 or more, making the total cost of a college education $200,000+ per child in many cases. This enormous expense is very difficult for many students to pay for themselves without a very heavy debt burden that can last for decades and hurt their ability to buy a first home, etc. Overall student loan debt has increased dramatically over the past several years. Most students need help to pay for college from loans, scholarships/financial aid, as well as from parents and grandparents.

A good way for parents and grandparents to help their children and grandchildren save for college is a 529 plan. These plans can be low cost, easy to manage, and offer some nice tax benefits. Most states have set up their own 529 plans, but you don’t have to use your home state’s plan. You (and your child) might live in Minnesota, use the Utah 529 plan for college savings, and your child may end up going to college in California. That is OK. These plans can be set up by anyone (parents or grandparents) for the benefit of any child. Anyone can contribute to the child’s 529 college savings plan (the child, parents, grandparents, relatives, friends, etc.). Most people keep their contributions below the current annual gifting limits of $14,000 per person ($28,000 per year for a couple).

What are the benefits of using a 529 College Savings Plan?

It can be a good savings tool that encourages you to increase your savings specifically for college costs for your kids or grandkids. They are also good gifting tools for kids and grandkids. The money in these accounts grows tax-free, and the money comes out of the accounts tax-free if used for educational expenses. Some states also offer some small tax benefits for residents who contribute to their 529 plans. The money can be used for any qualifying education expense for college, trade school, community college, graduate school, etc. You can change the beneficiary on the account to another child or family member if the child does not use some or all of the money for educational expenses. The parent or grandparent who sets up the account and acts as the custodian on the account retains control of the money, not the child. This prevents the child from spending the money on something they might find more “fun” than college costs, like a fast new car. Money in a college 529 savings account counts against you less than money in the child’s own name for financial aid purposes. The FAFSA financial aid benefit for 529 plans is the parental rate of 5.64% of assets, much lower than the student owned rate of 20%. These plans are simple to set up, maintain, and manage. They are very flexible. There are no income limits or age restrictions on who can set up 529 plans or benefit from them. Annual gifts to a 529 plan are removed from your estate, for estate tax purposes. You can front-load five years of annual gifting into a 529 plan, or a total or $70,000 in one year, without violating the gift tax rule annual limit of $14,000 per year.

What are the negatives of using a 529 College Savings Plan?

There is some risk that your child or grandchild will not go to college or will not need the money due to scholarships, inheritance, etc. Withdrawn earnings are subject to a penalty of 10% of the earnings plus income taxes for funds withdrawn that are not used for college costs. For this reason we recommend people not fully funding the expected total cost of college, but rather to fund up to a maximum of 75% of the expected cost in a 529 plan. Your investment choices are limited to the funds offered in each state’s 529 plan. You can only change your investment allocations once per year in a 529 plan. You don’t get a tax deduction for making contributions to 529 plans (Federal or Minnesota). You can’t get the gifted money back without penalty. It is a one-way transfer. If your child or grandchild is already older and closer to college age (age 14+ for example) the benefits of the tax-free growth in the 529 account are significantly reduced.

Which of the 50 state’s 529 plans do we like best?

We like the Utah 529 plan. It is one of the lowest cost plans in the country. They use mostly low cost Vanguard Funds in their plan, which we like very much. The Utah plan has a nice set of age-based investment models that do all the investing for you in a smart, low cost, diversified, risk appropriate way. These models get more conservative as the child gets closer to starting college and needing to spend the money in the account.

How much should I be saving each year for my kids/grandkids college costs?

We have developed a financial model to help with this question. To give an example, if the child’s college costs are expected to be $50,000 per year (in today’s dollars), and you wish to fund 75% of the total cost by age 18, and your child/grandchild is currently 3 years old, you would need to save about $7,500 per year (per child). This analysis assumes 3% inflation in college costs, 6% returns on your investments in the plan, and various other assumptions.

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