529 plans are tax-advantaged savings accounts to save for your child’s college education.
The technical name given to the 529 plan by the IRS is a Qualified Tuition Plan (QTP). Under this QTP, a contributor can prepay a beneficiary’s qualified higher education expenses at an eligible education institution — or contribute to an account for paying those expenses in the future. Distributions from 529 accounts are tax-free when used for qualified educational expenses. A great feature of 529 plans is that anyone can fund them, not just the parents. Finally, 529 plans are state-sponsored, so you must first choose a specific state’s plan; and in some instances, you don’t have to reside in that state.
Two types of 529 plans
There are two types of 529 plans:
- Prepaid tuition plan – This plan allows the contributor to prepay tuition costs at a rate determined by the state well in advance of the beneficiary ever stepping foot in a college classroom. A prepaid plan allows families to lock in tuition at today’s price, avoiding the risk of potentially rising college costs in the coming years. If the child chooses to attend a college that is not covered by the plan, he or she can still use the funds to pay tuition at other colleges that participate in the program. One downside is that most prepaid tuition plans do not cover certain college-related expenses, like room and board. Many states require the child to be a resident of the state associated with that plan; therefore, checking the residency requirement of the prepaid tuition plan is essential.
- Education savings plans–This plan type is a state-sponsored college savings account where a parent (or anyone else) can make after-tax contributions that can be invested. The account grows tax-deferred; qualified distributions are tax-free. There is no income limit on who can fund a 529 plan. One downside is that the state defines investment choices associated with the plan, which can be limited. In the event that the child chooses not to go to college, distributions taken for non-qualified purposes can potentially expose him or her to income tax liability and a 10% penalty on earnings; using those funds to serve another education need should be considered.
What are the differences between prepaid tuition plans and education savings plans?
The critical difference between a prepaid tuition plan and an education savings plan is where the funds are directed. A prepaid tuition plan uses today’s money to pay for college at a pre-determined rate locked in today. An education savings plan is a vehicle for investing money to pay for actual future education costs. Many parents and grandparents appreciate that a prepaid account provides some certainty by locking in tuition rates and potentially avoiding rising costs of education. On the other hand, the residency requirement associated with a prepaid account makes it a bit of a gamble.
An education savings plan allows for investment growth potential and a broader selection of educational institutions that will accept the funds. Qualified distributions under an education savings plan include items beyond tuition, such as room and board, books, fees, and computers. Contrast that with a typical prepaid plan, which is often limited to tuition (and, in some states’ programs, room, and board).
What fees and expenses will I pay if I invest in a 529 plan?
As with any other savings or investment opportunity, be sure to read the fine print. A contributor must carefully review plan circulars to understand all the one-time and recurring charges. Expenses can vary significantly based on the type of 529 plan. Typical fees can include an annual percentage of account value that the state will charge to administer the program, as well as account maintenance fees. If distributions are not used for qualified expenses, there is a risk of triggering income taxes and a 10% penalty on earnings. In general, you want to choose an education savings plan with a relatively low cost and a good set of investment options.
Possible applicable fees
Nobody likes to be surprised by hidden fees, particularly when saving for your kids. SYM Financial helps families find the right plan type and state sponsor— and understand the fees and investment options that apply. Keep in mind that prepaid plans often feature an enrollment or application fee and ongoing administrative fees. Education savings plans can have similar fees, plus an asset management fee. Families must do their research to find the optimal plan and strategy for their needs. Be aware that certain brokers can impose sales charges for opening a 529 plan account. While investment and account maintenance fees may be hard to avoid, you may be able to avoid the broker fee by shopping around.
As with any other financial decision, is essential to partner with an experienced financial advisor who has your best interests in mind. Finding the right plan at a low cost goes a long way toward achieving financial goals. Planning for college expenses is a critical piece of a solid financial plan, and SYM Financial works with clients to determine what plan makes the most sense for them.
529 Plans Fee Saving Tips
A significant consideration when seeking to minimize fees is to find the lowest-cost plan and a sound investment lineup. There are several online tools and resources that can help you compare plans by state, but those costs are constantly in flux. Below are some tips to help you keep costs low:
- Many states offer direct-to-consumer education savings plans that bypass brokers (and their fees). SYM Financial can guide you through this process.
- Another aspect to consider is account size. Administrative and maintenance fees can be reduced or even waived if the account balance is large enough.
- Automatic contribution plans may unlock lower fees, as certain states use this feature to encourage regular contributions.
- Be sure to elect electronic-only delivery of documents or online enrollment of statements. Many states plan to charge for the delivery of paper statements. In Indiana, the INvestABLE Indiana 529 plan has a $15 quarterly fee, but that fee can be reduced by $3.75 for those who accept electronic delivery of statements.
SYM Financial Advisors is here to help sift through all the details to find the best plan for your situation.
Are 529 plans worth it?
We’ve talked about the benefits of 529 plans before. 529 plans can be a valuable tool to help pay for the rising cost of college. Prepaid plans can be of tremendous value if college costs continue to rise as they have in the prior few decades, and if the beneficiary attends college in the state whose prepaid plan you have selected.
An education savings account offers tax-free growth, while capital gains tax is avoided upon distribution as long as the funds are used for qualified expenses. Certain states provide a state tax deduction on 529 contributions. You can read more about Tax-Advantaged Educational Savings Plans here.
529 Plan FAQs:
What happens to a 529 plan if it is not used for its intended purpose?
529 plan distributions face federal and state income tax liability, plus a 10% penalty on earnings, if not used for qualified expenses. This burden can be significant for families in a high tax bracket. The good news is that 529 plans are not limited to traditional colleges and universities. Funds can also be used for K-12 private school tuition (with certain restrictions), trade schools, and vocational schools.
If the beneficiary attends a U.S. Military Academy or receives a scholarship, the penalty is waived. For a scholarship, a non-qualified distribution up to the scholarship amount will come out penalty-free, but not tax free. The earnings on that amount will be subject to income tax.” Alternatively, the account could be kept active and used to pay for another family member’s college in the future.
Is a Roth IRA better than a 529?
Tapping a Roth IRA to help pay for college costs can make sense in some situations, but there are some risks to consider. A Roth IRA offers more flexibility than a 529 plan. If you decide to tap a Roth IRA, contributions are available to be withdrawn at any time tax-free and penalty-free. You must weigh that against the future opportunity cost of the Roth IRA account compounding over the years. Another consideration is that a 529 plan contribution can be tax-deductible in certain states, whereas contributions to a Roth IRA are not tax-deductible.
Do I need a 529 plan for each child?
You don’t have to have an account for each child. However, you should consider the likelihood of each child attending college in the future. While it is possible to transfer a 529 plan balance to another beneficiary, you must have a plan for the event that the first child runs the account dry. Having multiple accounts can help from a behavioral point of view; parents and family members can contribute an equal amount toward each child’s plan separately to keep things fair. You must weigh that against the need to keep records and pay fees on multiple accounts.
What happens to a 529 plan if a child does not go to college?
529 education savings plans offer portability. If the intended beneficiary does not attend college, the account can be transferred to another eligible member of the family.
What is the difference between an Education Savings Account (ESA) and a 529 plan?
An Education Savings Account (ESA), also known as a Coverdell account, is another method to help save and invest for college. Contributions to a Coverdell account are not tax-deductible; assets grow tax-deferred. Distributions are tax-free so long as they are used for qualified educational expenses. The major downside with an ESA is that the annual contribution limit is only $2,000. There are also income limitations on who can contribute to a Coverdell account. A positive aspect of an ESA is that many accounts have a broad range of investment options. However, it is also important to know that Coverdell account contributions can only be opened and can accept contributions until the beneficiary turns 18 and that the account must be spent down by the time he or she reaches age 30 (with certain limited exceptions).
529 Plan Advice from SYM Financial
529 plans have both financial and psychological value. It is hard to measure the peace of mind that comes from knowing that your family is doing the right thing by saving for your child’s future education. Part of sound financial planning includes providing for the next generation. SYM Financial Advisors is here to help make that happen. Our expertise in saving for college allows clients to live confidently. Be sure to explore our latest 529 Plans Redux summary at SYM.com/529-plans-redux.