In a family’s overall budgetary picture, children’s college savings are an important factor to consider. But parents should avoid the common error of prioritizing college savings above general financial health or retirement planning. Before the parental guilt kicks in, consider the following:
- There are many ways to fund a child’s education, including scholarships, financial aid, military service, two years at less-expensive community college and student loans. Unfortunately there is not a retirement golf scholarship, and retirement does not offer the same financing flexibility as college.
- Students can work before and during college. Sometimes unforeseen events or health issues prevent retirement-age individuals from working part-time or full-time, even if they wish they could.
- It takes a significant nest egg to fund the type of retirement that most couples desire. Generally people hope to participate in some leisure or recreational activities during retirement. You cannot get a loan for retirement, and most people prefer not to work full-time throughout life to fund their fun.
- If you’re a young parent, you may be in a better financial position to help your kids when college is closer.Typically, the first years of raising a family will be the most financially challenging. Some families choose to have only one parent work. Most young parents are still in the earlier stages of their careers, thus lower on the career ladder. Add the expenses of buying a home and a family-friendly car, and you can imagine that young parents are stretching themselves more than ever before or ever again.
- Many people find success in following a non-traditional path. There are countless stories of successful entrepreneurs who never attended college.
What is a 529 Plan?
Just because retirement and other savings are a higher priority than college savings does not mean that people should ignore their children’s educational funding. A 529 plan is an investment account that allows an individual to accumulate funds to be used for post-secondary education. Within a 529 plan account, there are several investment options. To the lay person, a 529 plan seems to function similarly to a Roth IRA that is for college instead of retirement – obviously there are some notable differences. Each state operates a 529 plan, but residents of any state can participate in any plan. In some cases there are tax benefits for using your home-state’s 529 plan.
529 plans are the investment tool that the IRS has designated specifically for tax-deferred college savings.
The biggest advantage of a 529 plan is the tax benefit you receive. When the money is withdrawn for qualified education expenses (tuition, room and board, computers, etc.) there are no taxes due on the earnings. There is an up-front tax deduction for contributions made to the 529 plan of the owner’s home state, and sometimes for other states' plans, which provides a triple tax-advantage: tax-deductible contribution, tax-deferred growth and tax-free withdrawals.
529 plans have become more common than Coverdell Education Savings Accounts (CESAs) because 529s offer more flexibility. For example, the beneficiary of a CESA cannot be transferred. CESAs were long called "education IRAs" because the contributions were tax deductible and enabled the owner to choose from a portfolio of investment options. However, 529 plans offer these benefits and generally have a wider variety of investment options.
Compared with Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) investment accounts, parents might see advantages in the ownership scenario of 529 plan accounts:
- Other custodial accounts, like UGMAs and UTMAs, become the possession of the child at the age of adulthood (between 18 and 21 depending on the state). The owner of a 529 plan account (usually the parent) retains ownership of the account at all times. This allows the parent to ensure that funds are used as intended.
- For the purposes of financial aid documents like the FAFSA form, the value of a 529 account is applied at the lower parental asset weight, reducing the expected family contribution versus an UGMA or UTMA account that is a student’s asset.
- The owner of a 529 account can change the beneficiary. This option would be especially valuable if a child decides not to go to college or chooses an institution that costs less than the value of the account. The beneficiary designation can be changed to any child or grandchild of the account owner. Note that a transfer of over $13,000 (in 2010) could be deemed a gift, and possibly subject to taxes.
The main disadvantage of a 529 plan is the restriction that the funds must be used for education-related expenses. Any withdrawal of earnings that is not for a qualified education expense is taxed as ordinary income and will be subject to an additional 10% penalty. One exception to the penalty is if your child earns a scholarship. In that event, you can withdrawal the amount of the scholarship from the account without facing the 10% penalty.
Something else to note about 529 plans: there is investment risk, as with any other investment. Most 529 plans use age-based investment options. Each provider has a different strategy for asset allocation for each age group. When the market dropped in 2008, some investors suffered devastating loses because some plans had high school students invested aggressively. Suffering a big loss in an account with a short time horizon makes it very difficult to fully recoup losses before needing to access the funds.
For official information about 529 plans, you can refer to this Securities and Exchange Administrationpublication. For helpful guidance and comparisons between 529 plans, Savingforcollege.com is an excellent resource.