What you should know about college-savings plans
Life’s possibilities are reflected in the cherubic cheeks of your newborn baby. First walk, first talk, first car, first boyfriend or girlfriend. Monumental events that culminate with a walk across a high school graduation stage into adulthood.
But will your bank account be ready for the next step, paying for a college education?
College tuition, fees, room and board costs have risen 57 percent since 2005-06 at public four-year universities and 38 percent at private institutions according to The College Board’s Annual Survey of Colleges. That means you’ll pay somewhere between $20,000 and $45,000 a year depending on the school.
College-savings plans, better known as 529 plans, are excellent tax-free ways to save from a child’s birth to dorm move-in. But it’s important to know the pros and cons of investing in them.
NEW! K-12 expenses now included. The definition of a 529 plan’s qualified education expense has been expanded to include K-12 expenses. Withdrawals up to $10,000 per student can be made for expenses related to enrollment at an elementary or secondary public, private, or religious school (home schooling is excluded). These withdrawals are tax-free at the federal level. Not all states updated their legislation to align with federal 529 legislation. Account owners interested in K-12 contributions or withdrawals should understand their state’s rules regarding how funds will be treated for tax purposes.
The tax implications. When you put after-tax money in a 529, any growth earned through its investments can be spent without paying federal or Ohio income tax if used for qualifying education expenses. Ohio also allows up to $2,000 of in-state 529 contributions annually per beneficiary to be deducted from your taxable income. If you have three kids, that’s $6,000 a year you can deduct. For tax purposes, your estate also is reduced by what you contribute to a 529 because it is considered a completed gift.
The availability. Forty-eight of the 50 states offer a 529 plan, and you aren’t limited to the state you live in. You can shop around and invest your money in any state’s plan, then use the money at any college, vocational school or post-secondary institution. But if you are an Ohio resident and go to a plan outside Ohio, you won’t get the state income-tax benefit. That might not matter as you can potentially find plans with lower management fees and better track records of return if you shop around.
The skipping college (or college on someone else’s dime) dilemma. If you save for your child over his or her lifetime, and he or she decides to skip college or scholarships cover most or all of the costs, all is not lost. You can change the beneficiary to another child related to you, even a niece or a grandson. Or save the money in case your child decides to go to graduate school or another post-secondary institution.
Locking in today’s prices. Prepaid tuition plans allow you to pay tuition and fees now without having to worry about tomorrow’s cost increases, even 15 or 20 years later no matter how the market performs. The number of these available plans are shrinking, and states that offer them (Ohio doesn’t) require the funds to be used for in-state schools. An independent national plan, the Private College 529, can only be used among the more than 280 private colleges that participate. The colleges bear all the market risk, not you. Room and board, however, isn’t covered, so you would still have to fund a separate 529 for that.
Benefits for grandparents. 529 savings plans can be a great way for grandparents to substantially contribute a student’s college fund. Plus, grandparents also control the assets and retain the power to control withdrawals from the account. By accelerating use of the annual gift tax exclusion, a grandparent (or anyone, for that manner) can elect to use five years’ worth of annual exclusions by making a single contribution of as much as $75,000 per beneficiary in 2019 (or $150,000 for a couple), as long as no other contributions are made for that beneficiary for five years. Assets contributed to a 529 plan are not considered part of the account owner’s estate and therefore avoid estate taxes upon the owner’s death. If the donor makes the five-year election and dies during that period, part of the contribution could revert back to the donor’s estate.
Funds contributed to a 529 plan are considered to be beneficiary gifts. Anyone, even non-relatives, can contribute up to $15,000 per year in 2019 per beneficiary without incurring gift tax consequences.
Higher management fees. According to SavingforCollege.com’s fee study, which looked at 10-year costs on a $10,000 investment in 529 plans directly sold by states, fees are all over the board in terms of what you will pay from more than $2,000 to zero-cost options. You will want to consider performance, too. If you go the broker-sold route, you’ll face sales charges as well as account fees. That could be tough to stomach if you’re only investing a little at a time. Be sure to do your research.
Not every college expense is qualified. The cost of living in a dorm and an off-campus house or apartment is a justified 529 expense as long as your child is enrolled at least half time. But if the off-campus expenses exceed the school’s room and board allowance, the excess can’t be reimbursed through the 529. That’s where putting your money into a Roth IRA could make more sense. Penalty- and tax-free distributions for education-related expenses are allowed the same as 529s. But by withdrawing only the principal, you can cover what the 529s can’t such as transportation costs, sporting event tickets and student loan repayments. If you leave the Roth IRAâ€™s earnings alone, the withdrawal is still penalty- and tax-free.
The skipping college (or college on someone else’s dime) dilemma, part 2. If there just isn’t another beneficiary for your money, you obviously want that money back. But you will pay the full income tax and a 10 percent early withdrawal penalty on earnings. If your child does go to college on scholarship, you can withdraw the amount of scholarship money received from the 529 without incurring the 10 percent penalty. You can also use the 520 plan for off-campus residency, books, supplies and computer. Other penalty-free instances include attending a U.S. military academy or death or permanent disability. But you will still be responsible for the income taxes.
A 529 savings plan is an excellent way to pay for college, but it is not the only way. Many states, including Ohio, offer grants and scholarships that often don’t have to be repaid. And you can consider a home equity line of credit, which often have lower interest rates than a credit card and some federal student loan rates. The interest also is deductible up to $100,000 from your federal taxes.
Remember, however, that you will be putting your home up as collateral for the loan. Talk to one of our knowledgeable lenders, who can help walk you through the specifics on whether a home equity line of credit is right to fund your child’s education.
Top-rated 529 plans
Morningstar, a top independent investment research company, rated the largest college-savings plans in the U.S. to determine which ones would be more likely to outperform its peers over the long term based on the five Ps (process, performance, people, parent (stewardship and oversight) and price). The top three, rated Gold, are all direct sold by states and are open to both residents and non-residents. For the complete 2020 ratings list, Morningstar’s most recent, click here. Of note, Ohio’s CollegeAdvantage 529 Savings Plan, managed by the state, is a highly rated Silver fund. North Carolina’s National College Savings Program and South Carolina’s Future Scholar 529 (Direct) are both rated as a Bronze funds.
Investments are not FDIC insured, not bank guaranteed, and may lose value.