“The need for a college education is even more important now than it was before, but I think that the increased costs are a very severe obstacle to access. It is an American dream, and I think that one of our challenges is to find a way to make that available.” – Roy Romer
State-sponsored 529 college savings programs (also known as qualified tuition plans) made the news last fall because Congress has made their tax-free earnings status a permanent thing.
If the newspaper articles raise awareness about these programs, so much the better. They are very helpful for middle-income families who want to pay for college expenses without going into debt.
In ETR #1943, I suggested that it’s the responsibility of the parents – not the government – to make sure their children have a good elementary and high school education. That means investing both time and money. But when it comes to a college education, the responsibility has always been borne by individuals – the parents and/or the students. In fact, next to a house, college tuition is the biggest financial burden that most families face.
Why not lighten the load by (1) paying for tuition and school expenses in advance or (2) beginning to invest for that education today on a tax-exempt basis?
These are the primary benefits of the 529 programs: Earnings grow tax-free at the federal level and, in some states, at the state level. In a few states, even contributions to the plan can be tax-deductible. (But there is NO deduction for contributions on the federal level. This does not function like a traditional IRA.)
Tax-free growth is why these plans are so popular with forward-thinking parents. (Since 2001, 529 assets have risen steadily from $13.6 billion to $97.3 billion this year, and they are expected to continue to climb in the future.)
529 programs do have limits and trade-offs, however. So I asked Justin Ford, creator of the Seeds of Wealth program, about 529s. This is what he told me:
“There are two primary types of 529 plans – 529 Savings and 529 Prepaid.
“Prepaid plans are offered by most state universities and a growing number of private schools. They can be offered by an individual institution or a group of institutions for education expenses for that university or state university system. Prepaid plans lock in your cost today for much of your future educational expenses. They are often guaranteed by the state. Your choice of university, however, is limited by the plan you choose. Yet, if your child decides to go to another school, you can sometimes roll your account over.
“College savings plans are more flexible but they do involve more risk. They are basically state-sponsored programs that allow you to open a tax-exempt investment account on behalf of the child or children whose education you are saving for.”
The key benefit of the college savings plans is that you have more choice over:
- Who manages your money.
- What investments you can make.
- Which schools you can choose.
For example, Schwab’s 529 savings plan offers a choice of 10 investment portfolios. The proceeds can be applied to any qualified school in the U.S., with full federal tax savings.
Some 529 college savings plans offer guaranteed minimum returns. Others don’t.
What’s important to know about college savings plans, Justin pointed out, is that they are NOT guaranteed by the state, the FDIC, or anyone else. So with some 529 savings plans you could end up with less than you put in.
Setting up a 529 savings plan will have an effect on your child’s ability to get financial aid, but the decrease is very small – just pennies on the dollar, according to Schwab. And if it’s held in an uncle’s or grandparent’s name (as opposed to the parents’ names), it doesn’t reduce the child’s eligibility for financial aid at all.
“Even if there is a slight reduction in eligibility for financial aid, so what?” Justin said. “It’s better to make a lot of money even if it puts you in a higher tax bracket. Likewise, it’s better to invest for your kids’ education now than pin your hopes on future aid programs.”
There are other saving options for your children’s college, but most, like the Coverdell Education accounts, have caps. (In the case of the Coverdell Education accounts, the cap is $2,000 a year.)
Justin said that he has seen no contribution or income limits for 529 plans stipulated on the IRS website, other than the stipulation that contributions “cannot be more than the amount necessary to provide for the qualified education expenses of the beneficiary.”
Another option is to put money into a family limited partnership that you control (and in which your children are minor investors). The income they get would be taxable, but the basis can be adjusted downward since the children are limited partners and don’t have control over the important decisions that affect the money’s value.
Yet another option is a regular taxed account for minors in UGMA or UTMA accounts (under the Uniform Gift to Minors Act and the Uniform Trust for Minors Act). These would have no contribution limits and offer complete flexibility.
“You may realize some tax savings from these accounts,” Justin said, “especially in the beginning, simply from the fact that minors have lower overall earnings and therefore lower tax liability than you would likely incur from your account.
“Of course, you’d get no minimum guarantee or locked-in tuition with this account,” he added.
Which brings us back to the 529 programs – my personal recommendation. I like them because they are simple and because they are flexible. If you are in a position to help your children or grandchildren, now is a great time to choose one.
But before you make your final decision, check out some of the government websites on the topic for more info, including the College Savings, Securities and Exchange Commission, and IRS websites. Then contact the sponsors of the specific plans you may be interested in and quiz them on fees, investments, and flexibility of the use of funds.[Ed. Note: Check out more unedited, uncensored (and sometimes unexpected) ruminations on Michael Masterson’s Blog] [Ed. Note: Mark Morgan Ford was the creator of Early To Rise. In 2011, Mark retired from ETR and now writes the Palm Beach Letter. His advice, in our opinion, continues to get better and better with every essay, particularly in the controversial ones we have shared today. We encourage you to read everything you can that has been written by Mark.]