A 529 Update

I have written about 529 college saving plans in a previous article. If you are considering starting to save for your children or your grandchildren, I recommend you read this introductory article and a great deal more before you decide where to invest your hard earned cash. Like anything that involves the IRS, not to mention the tax codes of our 50 states and commonwealths, things can get a little tricky.

An Introduction to 529 Plans

529 plans are not a subject that comes up very often in my conversations. Most people are worried about finding a job that pays more than minimum wage, getting out of debt, and finding a foolproof financial plan for their retirement. However, if you are well on your way to financial freedom, funding your progeny’s educational aspirations is a worthy goal. Dave Ramsey lists it as Baby Step Number 5 of 7. Ramsey puts this after saving a full 15% of your gross income in tax favored accounts for your retirement, but before making extra payments to principal on your mortgage. I might put a 529 after paying off your mortgage early, but it’s your life. If you are this far down the road to financial freedom, you are doing a good job.

In their most recent list of new monthly articles, Schwab notes there are five costly mistakes to avoid when using a 529 to save for the cost of a college education. Some of them seem rather obvious, but a few are new to me, so I thought I should pass them on to you.

1) Don’t assume that your 529 is going to going to grow. Anytime you invest in stocks and bonds, you are placing your money at risk. The funds you have purchased may go up or they may go down. Buy and hold never means buy and forget.

2) Every year check your allocations and your contributions. If you use a target date fund, your holdings will be automatically rebalanced on a regular basis. If you are selecting your own funds, your allocations could get badly out of balance over time. As with retirement as you get closer to your goal the risk level of your portfolio should decline. If the amount you are saving isn’t going to send Junior to his dream school, you might want to increase your contributions.

3) You have until April 15 to make contributions to your IRAs, however any contributions to a 529 must be made by December 31. Schwab also notes that if your contributions to a child’s 529 exceed the Federal $14,000 gift tax exclusion, you will need to file a gift tax return. If you find exceeding this limit to be a problem, I salute you.

4) Timing your withdrawals can be a problem. You are only allowed to withdraw enough money to cover “qualified college expenses” within that calendar year. Watch out if scholarships are covering some of these expenses. You could end up with a nasty surprise from the IRS.

5) What happens if Junior doesn’t need or can’t use the money? This money can only be used for “qualified college expenses” as defined by the IRS. If you withdraw the money for any other purpose, you will be taxed and hit with a 10% penalty. If Junior gets a scholarship, you can withdraw the exact amount of the scholarship and the 10% penalty will be waived. If Suzie is accepted to Oxford, you are out of luck. You can’t use the money in her 529 to send her to a foreign institution. You can continue to save it for the cost of graduate school, if she comes back home after matriculating at Christ Church College. If she decides to stay in England, you can make one of her siblings a beneficiary of those funds or you can use them to further your own education or for the education of your grandchildren.

Please be careful. Be sure to consult with your CPA before investing in a 529 or withdrawing money from an existing account. For most Americans, the 529 is the best available option. However, I believe it could be improved.