How will you pay for your children’s college expenses?
Tuition rates for both private and public universities across the country are dramatically increasing. The average student loan debt for a college graduate is over $37,000 according to a study done by US News.
What can you do to reduce or even eliminate this future expense to your kids?
As a parent, I want to financially support my children as best as possible when it comes to their education and professional future. You may be the same.
There are various ways for parents to plan ahead and save for college. Today we will review one of the most common and effective strategies: the 529 plan.
- The Need to Save
- PROS of a 529
- CONS of a 529
- The Need to Save
College may sometimes seem like it will cost an arm and a leg.
If planned properly, this looming cost can be accomplished with consistent savings, professional advice and the discipline to start saving early while your children are young.
The figure of $37,000 referenced earlier only considers undergraduate college costs, not post-secondary school like graduate, medical or law school.
Today’s average cost at an Illinois public university is $24,610 per year while a private university like Yale or Harvard sets you back up to $49,320 per year.
Before you dismiss these costs thinking your kids can take loan after loan to earn their degree, think about this for a second.
Student loans cannot be discharged even through a bankruptcy filing unless you are able to prove “undue hardship” to the court.
Depending on the type of student loan, it may not be forgiven at even the borrower’s death unless the loan was issued by the U.S. Government. If the loan is discharged, there may be tax implications with the forgiven loan claimed as taxable income. Consult with your tax advisor on this matter.
Lastly, college tuition is increasing in price. Inflating at approximately 5% each year for the last ten years according to www.savingforcollege.com. This means the cost of college is rising twice as fast as the rate of inflation.
The value of education is becoming more crucial which in turn leads colleges to raise student tuition rates.
If parents decide to save for college in savings accounts or bank CDs they most likely won’t hit their savings goals given the ultra-low interest rate environment we are in today.
As a parent, consider educating yourself on all the college savings options available today. These may include Coverdell ESAs, UGMA/UTMA custodial accounts and brokerage accounts.
- PROS of a 529 College Plan
The largest benefit of a 529 college savings plan is the ability to use this account for qualified education expenses without paying taxes on the growth or earnings of the 529.
Qualified expenses include tuition costs, room & board and school supplies.
The 529 account owner is the parent, the beneficiary is the child. The beneficiary is portable meaning you can change it to your other kids if they need to use the funds for their education.
Parents are able to save after-tax money into a 529 account as frequently as they prefer. There is no tax-deductible contribution into a 529, unlike your 401k retirement plan where you get to deduct from your taxable income what you contribute.
One similarity a 529 has with a 401k is that contributions are invested in mutual funds. Our team uses lower cost ETFs (exchange traded funds) through an Illinois 529 program. Earnings are based on the performance of the mutual funds you or your advisor select. Investors can re-balance their portfolio twice per calendar year.
As 529 accounts go up or down in value each year, there are no tax implications on the gains or losses. For some states including Illinois, parents receive a state tax deduction on their contributions into a 529 with applicable limits.
An easy example is if a married couple saved $20,000 into a 529 for the calendar year, this couple could write off $990 from their state taxes ($20,000 x 4.95% IL state tax).
If you have multiple kids close in age it is advisable to have one 529 account. With one large account the compound interest will accumulate at a faster rate instead of various smaller accounts growing minimally. Each family situation is different, consult with your Certified Financial Planner before making any decisions.
529 plans can be used for any qualified educational institution across the country. If you have an Illinois 529, you can use it to pay for school in California or New York, the choice is yours.
A common question we get is “what if my child receives a scholarship?”
In this case the earnings of your 529 are not penalized, however a withdrawal will be considered taxable income to you or your child. In other words, your 529 turns into a tax deferred investment vehicle similar to a 401k plan. Money grows without paying taxes, then upon withdrawal of funds, ordinary income tax is charged.
If your child decides to pursue post graduate education, they may use the 529 funds without taxation on the earnings. Examples include but not limited to nursing school, medical school or law school.
Lastly, there are no income limits or contribution limits when contributing into a 529 plan. Unlike other college savings plans like a Coverdell ESA plan that restricts a family if household income filing married is over $190,000. These Coverdell plans are best used for private grade school and/or high school.
Regardless of your income level, 529s can be an effective and tax efficient vehicle if used for your children’s education needs.
- CONS of a 529 Plan
The largest drawback of using a 529 plan is if the parent does NOT use the
account for qualified education expenses. A 10% penalty is charged on the earnings and the account owner is then taxed on the withdrawal as ordinary income.
For this reason, it is advisable to not over-fund a 529. Proper financial planning should be completed to calculate realistic college costs for your situation and to reduce the chance for future penalties and taxes.
A common question I hear is, “does a 529 affect financial aid?”
The short answer is yes; however, a 529 is looked at favorably on the FAFSA (Federal Application for Student Aid) formula.
529’s are considered parental assets on the FAFSA form.
This is a good thing because parental assets are treated favorably compared to assets held in your child’s name for example a custodial UTMA or UGMA account. This account is owned by a minor and allows investments such as stocks and mutual funds.
To better understand here is an example. A parental asset reduces a student’s aid package by 5.64% of the assets value. Meaning if a parent has a 529 worth $10,000, the child’s financial aid would be reduced by $564 ($10,000 x 5.64%).
The tax advantages with 529 withdrawals may likely outweigh this smaller loss. Other assets owned by the student reduces the student aid by 20% vs. 5.64%. That same $10,000 invested in a custodial UTMA account will reduce the aid by $2,000 ($10,000 x 20%).
Qualified 529 withdrawals are NOT counted towards the FAFSA application whereas withdrawals from mutual funds in a brokerage account or even IRA distributions are considered income and will lessen the student aid available.
Another drawback for some can be the small selection of investment funds from which you are able to choose. Similar to some employer 401k plans that only offer 10-15 funds, some state 529s are built the same way. This means less ability to diversify your portfolio properly if handcuffed to a smaller pool of mutual funds.
Beware of high cost mutual fund classes. Some “C share” mutual funds may charge the investor over 1.5% per year, eating into your portfolio balance day by day.
Lastly, 529s have limits when attempting to use overseas. In order to use a 529 plan to cover education expenses outside the USA, the educational institution in the foreign country must participate in the USA Federal Student Aid program.
A 529 savings plan if used correctly, coupled with proper professional advice, can be a very effective way to save for your children’s college expenses. There are over 100 different 529 plans available in the U.S. with each of the 50 states sponsoring their own 529 programs.
My team and I can help evaluate all types of college savings vehicles for parents including all 529 plans across the country.
As an independent CFP that is legally obligated to act as a fiduciary for your best interest, I can give you that much needed second opinion over a no-cost college savings review. Contact me below.
More about the author
As an independent Certified Financial Planner in Bartlett, IL, my practice specializes in three specific professions:
Medical professionals, business owners and government employees.
Our goal is to save you precious time, stress and your hard-earned money versus tackling this all by yourself. Let a skilled team of experts like us, already familiar with your employer benefits, unique needs and goals guide you through the constant changes in your life towards ultimate financial independence.
The above article is informational in nature only. Individuals should always consult with their tax advisor regarding their personal tax situation.
Dustin Javier, CFP® AWMA®
CERTIFIED FINANCIAL PLANNER™
President | Dean Johnson Advisory, LLC
Securities and investment advisory services offered through Ausdal Financial Partners, Inc. Member FINRA/SIPC. 5187 Utica Ridge Rd., Davenport, IA 52807. (563) 326 2064. www.ausdal.com Dean Johnson Advisory and Ausdal Financial Partners are independently