529 College Saving How-To

Advantages of a college education: potentially higher income, self-improvement through learning, friendships to last a lifetime. One big disadvantage: hefty costs. Start saving for higher education now – and, just as important, start saving the right way.

For the last 50 years, college costs rose at roughly 7% annually, nearly double the consumer price index during that same period. Overall costs of some higher education, including even community colleges, jumped 24% beyond inflation in the last five years, according to the College Board. There are some signs that this is slowing but there's no question a college education can be expensive.

There are lots of college investment vehicles to help you counter this trend. This first of two articles looks at 529 plans.

Individual states or financial institutions typically sponsor 529s, perhaps the most common type of college savings plan. You can use the money for attending college anywhere in the country and as long as the money goes for qualified education purposes, earnings are tax-free. Sometimes your contribution also gets a state tax deduction.

You can gift up to $14,000 (in 2014) per student each year, known as the “annual exclusion” amount for tax purposes. A special exception for 529 plans allows you to contribute up to five times the annual exclusion, up to $70,000 per child in any one year. Keep in mind that you then use up the annual exclusion for five years.

You can also transfer leftover money in a 529 to a plan for another qualified beneficiary. Qualified beneficiaries include: siblings or parents (or ancestors of either); nieces or nephews; aunts or uncles; first cousins; in-laws; and spouses of any of these. Ability to use 529 money for another beneficiary is a unique feature unavailable when you use other college savings vehicles such as Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA ) accounts.

Parents (or owners) maintain control of the assets in a 529 plan until distribution; the financial aid formula incorporates the assets at an advantageous rate. Disadvantages to 529s, however, include:

  • You are limited to changing investments just once a year and, although the number and quality of investment choices recently improved, limited to options in your chosen plan.
  • Sometimes costs run higher than in alternative investments.
  • Assets not used for qualified college expenses subject the plan’s earnings to income tax and a 10% penalty (avoid this by rolling the plan over to another qualified beneficiary).
  • High-net worth families especially might use the annual gift tax exclusion better in another way. For example, you pay tuition directly to the school and do not count it toward the gift tax exemption. You may also want to use your annual exclusion to fund a family trust.

If the advantages outweigh the disadvantages, how do you choose among the plans available? Important factors are:

  • Many states offer tax deductions for residents investing in a home state's 529 plan. Some also offer generous matches for first-time enrollment – an attractive incentive. Don’t ignore other fees and the potentially limited investment choice, though, especially when the tax advantage is relatively small.
  • The right investment alternatives are critical. Especially in volatile markets like we see lately, you need investment options and broad selections that give you confidence. Many plans recently added fixed-income choices that do just that.
  • Not only do you pay a fee to the plan managers, you also pay a fee for the individual mutual funds the plan invests in. Account for both of these costs when comparing the total expenses of various 529 plans. Don’t choose a plan with a low management fee only to find out later that the individual funds come with very high expense ratios (or vice-versa).

(Our next article examines alternative ways to save for college, including UGMA/UTMA and individual retirement accounts.)

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Sue Stevens, CFA, CFP, CPA/PFS, is the chief executive and chief investment officer of Stevens Wealth Management, in Deerfield, Ill. She was director of financial planning at Morningstar for nine years where she won awards for her online columns and founded their personal finance newsletter. Sue is frequently named as one of the top advisors in the country by Worth, Bloomberg, Reuters and others. Sue has twice been named one of 50 Distinguished Women in Wealth Management by Wealth Manager Magazine and AdvisorOne. Her new book, Radiant Wealth, has won three awards.

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