Thursday, December 5, 2013

An Introduction to 529 Plans

Try to imagine what I would think about plans defined under not only the Federal Tax Code, but the different laws of the 50 different states that have made special deals with major investment houses, some of whom use commission salesmen. There is no single 529 plan for college savings. It is a snake pit of different sorts of offerings from 50 different states. If your state offers a really bad plan with limited selection of funds and high fees, it might be worth your while to consider another state’s plan even if your state doesn’t offer reciprocal tax deductions for your contributions.

As readers of this blog know, I consider saving for your children’s education to be a “nice to have” rather than a “must have.” It is more important that you escape all forms of debt and prepare for your retirement than it is to send your children to college. Many college degrees are at best a dubious investment. Due to the popularity of government guaranteed student loans that must be paid even in bankruptcy, institutions of higher education have run wild. Over the last 30 years the cost of higher education has increased at 5 times the rate of general inflation. Your financial independence in retirement would be a better gift to give your children than a college degree with the opportunity to support you in your old age. However, if you are intent on saving for your children’s or grand children’s education, 529 accounts offer a tax advantaged means of accomplishing this end.

There are two kinds of 529 plans. The least common is prepaid tuition. Eight states offer you the opportunity to buy future education at their universities at today’s prices. Maryland’s plan allows the money to be spent at any Maryland public college or university. It also allows the use of an amount equal to “weighted average tuition” to be used outside the state. This is pretty important. You may imagine that Junior will follow in your footsteps, selecting a major in electrical engineering at your dear old alma mater, when in fact he may have his sights set on a double major in art history and ecology appreciation at a private school in another state.

The more common 529 plan is a tax favored savings plan. These plans typically invest in mutual funds. Their value rises and falls with the market. Like retirement accounts, most authorities recommend an age appropriate balance between bonds and stock funds. Let’s say granddad starts a 529 plan for Junior on the day he was born. Since the amount of money is small (say $3,000) and the time frame is long (18 years) this money should be invested aggressively, even knowing that a market crash occurs once every ten years. Let’s say at age 17 the investments in the account are worth $150,000. Junior is going to need all that money over the next four years plus another $50,000. Now is not the time to be gambling a 4% difference in average return between stocks and bonds against a 1 in 10 chance of a 40% drop in the total value of the account.

Here is where it gets tricky. While states administer these plans under their own laws, they generally partner with a mutual fund company or a brokerage house. While some states offer a diversity of low cost products, some offer a few products loaded with high fees.

Let the buyer beware.

Here is a link to an article by the well respected Liz Weston of MSN Money listing some of the best and worst state plans. Again, it is not only necessary to evaluate different plans, but you also must consider the effect of the plan you select on your state tax return.

Best and Worst 529 Plans

529 Accounts have a donor (who manages the account) and a beneficiary (the child). Once the money goes into the account it pretty well has to be used for the education of the beneficiary. Otherwise, any gains are subject to taxes and penalties. There are exceptions, such as the death of beneficiary. However, consider that money as limited in use to tuition, fees, books, supplies, and equipment related to study at an accredited college, university or vocational school. These funds can also be used to pay room and board in most situations.

Warning: Paying tuition directly from a 529 account may reduce a student’s eligibility for need based financial aid.

Warning: Contributions to a 529 account fall under Federal Gift Tax Regulations. The donor is limited to $14,000 in a single year or a total of $70,000 over five years.

On the plus side, although money contributed to a 529 can not be deducted from your federal income tax, you might get a state deduction, and the money does grow tax free. The money still does belong to the donor. In an emergency the donor has access to those funds for any purpose after the payment of taxes and penalties. The states offer their own extra benefits to participants in their plans. For example Arkansas offers matching money to low income residents who have a 529. Maine offers $500 to start a 509 account for any baby born in Maine or a child who moves into the state before their first birthday. If your child is not interested in higher education, the money you saved can be used to benefit most other members of your family.

If you want to save for a child’s education, the 529 is the vehicle of choice. Once in place, it is basically a hands off tool that allows your money to grow protected from the ravages of the tax man.

But for heaven’s sake, Let’s be careful out there.

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