The substantial rise in recent decades of the cost of a college education is a serious hardship for most families. Student loans may mitigate the difficulty temporarily, but excessive borrowing can become problematic in itself. A better approach for a family, one that requires foresight and planning, is to start accumulating money well in advance of the need to enroll a student in college.
College tuition costs have risen at a rate that has far outpaced the Consumer Price Index (CPI), which is a proxy for general inflation in the economy. Between 1978 and 2021, the CPI increased by 326%. College tuition costs have risen at a rate of over 1,426% during this period.
We recommend that a family’s college savings target be the full cost of a college education in the year in which child is born. This can be expected to cover about one-third of the total cost of college when the child enrolls.
The key to saving for college is to start early. The sooner you start saving, the more time for your contributions to add up and be supplemented by the return you earn on your investments within the account. Special tax advantaged financial accounts known as 529 Plans have proven effective for this purpose by providing an incentive for families to save for college. As of August 2020, more than $360 billion was invested in 529 Plans in the U.S.
There are two types of 529 Plans: prepaid tuition plans and education savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 Plan. In addition, a group of private colleges sponsor a prepaid tuition plan. While you are allowed to invest in out-of-state education savings plans, there are significant advantages to savers who choose to open a 529 Plan in their state of residence. These may include state tax advantages, grant and scholarship opportunities, protection from creditors, and exemption from state financial aid calculations.
Contributions to 529 Plans are made with after-tax dollars. 529 Plans may be partially or fully taxable (even if used for qualified expenses). The two types of 529 Plans are:
529 Prepaid Tuition Plans
These plans allow a plan-holder in some but not all states to purchase years, credits, or units of tuition at participating public, in-state colleges for future tuition payments at current tuition rates for the student. Prepaid tuition plans cannot be used to pay for other future college expenses like room and board, books, and equipment.
Most prepaid plans are sponsored by state governments and have residency requirements for the plan-holder and beneficiary. They are not guaranteed by the Federal government. Some state governments guarantee the money paid into the plans that they sponsor, but some do not. If your prepaid tuition payments aren’t guaranteed, you may lose some or all of your money in the account if the plan’s sponsor experiences financial difficulties. If the beneficiary doesn’t attend a participating college, the prepaid tuition plan will pay out less than it would if the beneficiary does attend a participating college. An account may only pay a small return on the sum of the contributions depending upon how successfully the funds have been invested.
Additional information about prepaid tuition plans will be provided in a future post.
529 Education Savings Plans
Education savings plans let a family open an investment account to save for the beneficiary’s future higher education expenses — room and board as well as tuition and fees. Withdrawals from education savings plans can generally be used at any college in the U.S. and some non-U.S. colleges. Education savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at a public or private elementary or secondary school.
An accountholder may choose among a range of investment portfolio options, which usually include a variety of mutual funds, exchange-traded fund (ETF) portfolios, and principal-protected bank products. Families should consider all investment options before selecting among them when setting up an account. Accountholders retain the right to make changes to the investments during the life of the account.
The available investment options may include age-based portfolios (also called target-date portfolios). Age-based portfolios gradually shift toward more conservative investments as the beneficiary gets closer to college age. Many accountholders will tolerate less risk as they get closer to withdrawing the funds.
All education savings plans are sponsored by state governments. Only a few have residency requirements for the accountholder and beneficiary. State governments do not guarantee investments in education savings plans. Plan investments in mutual funds and ETFs are not Federally guaranteed, but investments in some principal-protected bank products like certificates of deposit are insured by the FDIC. As with many investments, those in education savings plans may not make a return on the money invested and may lose some or all of it.
Features of 529 Plans
Key characteristics of 529 Plans are:
- There are no joint accounts in 529 Plans. Only one person can own an account.
- The funds in a 529 Plan can be transferred to another 529 Plan. This type of transfer is called a rollover. Under Federal tax laws you are allowed to roll over a 529 Plan to another 529 Plan for the same beneficiary once per year.
- If your child earns a scholarship to college, you can withdraw the amount of the scholarship award from your 529 account without penalty, but federal and state income taxes on the earnings will apply.
- You need to have a different 529 plan account for each child because an account can have only one beneficiary.
- According to the Federal regulations, the most you can save in a 529 account is the expected cost of a college degree. States have set limits based on this guideline.
- On an annual basis, any amount contributed to a 529 account over the annual Federal gift-tax exclusion would need to be reported to the IRS as a gift and would count against your lifetime gift tax exclusion.
- You can “superfund” a 529 Plan by contributing five years’ worth of your annual Federal gift tax exclusion at one time.
- If your child does not attend college, you can take a non-qualified withdrawal of the entire balance in the account. If you do, any earnings (capital gains) in the account that are withdrawn are subject to Federal income tax plus a 10% penalty.
- As an alternative if your child does not attend college, you can transfer the balance on the first 529 Plan account to a new account with a new named beneficiary. The new beneficiary must be an eligible family member of the original beneficiary in order to avoid Federal income taxes and the 10% penalty on the earnings.
- You can ensure that the funds in a 529 account will be used solely for educational purposes because the student/beneficiary has no legal right to the funds in the account under any circumstances.
- Both types of 529 Plans normally generate rates of return on assets that are less than those generated by certain other types of investment vehicles that families use to accumulate funds for college education.