If you’re a parent, odds are you’ve already been mulling over how you’ll help pay for your kids’ higher education when the time comes.
It’s no secret that college costs have been skyrocketing. For example, the average $110,000 cost of a 4-year undergraduate degree is around 14 times higher than it was in 1977. Compare that to the average cost of goods and services, which has “only” quadrupled over the same period.
To help cover the hefty costs, 529 college savings plans have become a key, tax-wise tool many families use to pay qualified education expenses. The most common scenario is parents, opening 529 accounts to benefit their children. But the account owner can typically be anyone over age 18, and the beneficiary does not have to be your offspring. (Grandparents, uncles, aunts, we’re talking to you!) You can even set up a 529 plan to cover your own college costs.
Before you get started, here are five questions to ask as you review which 529 plan (if any) is right for you and your college-bound kids.
1. What’s a 529 plan have that my regular investment account doesn’t?
You contribute to a 529 plan with after-tax dollars, so on that count, there’s no special incentive. But there are a number of significant tax benefits available after that.
- Potential state tax deductions: Many states offer full or partial state income tax deductions for 529 contributions.
- Tax-sheltered investment growth: Investment growth in a 529 plan is tax-deferred.
- Tax-free withdrawals: As long as you use the funds for qualified education expenses, withdrawals are tax-free when you take them.
In short, as long as you spend the proceeds on education, you should end up significantly reducing the capital gains taxes you’d normally incur if you held the same investments in a regular account.
2. Should I use my own state’s plan, or an out-of-state plan?
Home may be where the heart is, but that does not mean your home state’s 529 plan is automatically your best choice.
- Tax ramifications: Each state has its own rules on whether 529 plan contributions are tax-deductible and, if so, to what extent. If your state offers generous tax breaks, this may tip the scale in favor of an in-state 529 plan. Here’s a resource for learning more.
- Quality control: While nearly every state offers some form of state-sponsored 529 college savings plan, some are far more appealing than others. It’s definitely worth comparing qualities such as investment selections, costs, ease of use, whether the holdings count against state student loan eligibility, and overall management.
Finding the right 529 plan for you can require balancing all these factors and more. It might be worth engaging a financial planner to help you make an informed choice on whether your own state’s 529 plan tax savings would outweigh any out-of-state plan advantages.
3. How do I decide when to use the funds?
Here’s a critical, but often overlooked point: Since a 529 plan’s greatest benefit is its potential for tax-free, long-term investment growth, it stands to reason your plan needs plenty of time to do its thing. So, the earlier you open your children’s 529 accounts, and the longer you can let those accounts grow, the better. For example, even though high school tuition now counts as a qualified 529 plan expense, you may want to pass on that offer, and wait until your child is college-bound before tapping into these funds.
4. What can I do if things change?
Of course, life doesn’t always go as planned. Kids postpone or opt out of higher education. Or they may receive generous scholarships to pay the way. Then what? If you don’t spend your 529 plan assets on qualified expenses, they’re generally subject to income tax on the investment growth, plus a 10% penalty upon withdrawal. That said, some flexibility exists:
- Scholarship offsets: You can take withdrawals from your 529 plan equal to qualified scholarships received. You’ll pay capital gain taxes, but you won’t have to pay the 10% penalty. So, essentially, you’ll spend no more on taxes than if you had invested the proceeds in a regular account to begin with.
- Change beneficiaries: You can change the beneficiary to another family member, or even earmark the account for future grandchildren.
- High school expenses: As touched on above, 529 plan funds can now be used for qualifying private K-12 education expenses, if needed.
- Student loan debt: You can use up to $10,000 to pay down student loan debt. This is not limited by account, but by individual. For example, you could withdraw $10,000 for your first beneficiary, then change to a new beneficiary and use another $10,000 for his or her debt as well.
5. What if I can’t afford it?
Before we wrap, it’s worth pointing out an elephant in the room: There’s often a lot of pressure on parents (or even grandparents) to pay their kids’ way, even if it might put their own financial stability at risk.
What if you can’t afford to fund your retirement and your children’s higher education? If that’s the case, we encourage you to prioritize and weigh your options carefully. You may decide to help pay for college only to the extent that your other goals are not significantly impacted. Or, you may be willing to commit to working longer or cutting back in other areas to give your offspring a head-start.
Neither choice is “right” or “wrong” for every family, which is why it’s best to be candid as you assess which choice is right or wrong for yours. However you proceed, it usually helps to let your children in on the conversation. By vesting them early in their future possibilities, you can best pull together toward making that future as promising as possible for everyone.
Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.