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How to pay for college in 18 years’ time weighs heavily on the minds of new parents. A quick google search of college savings plans returns a plethora of options and jargon than doesn’t ease these new parent worries or those of parents who think that they may be too late to save for college. Let’s take a closer look at the options parents (and grandparents) have when choosing a 529 College Savings Plan.
A 529 plan is a savings plan with tax breaks that is specifically for paying for education. The law was recently expanded to cover K-12 education and apprenticeship programs making it a more flexible education savings tool. A 529 savings plan grows tax-deferred, and withdrawals are tax-free, if they’re used for education expenses.
Choosing a 529 Plan
Parents and grandparents (and anyone else), can invest in any state’s 529 plan, not just in the state they reside, so shopping around may find you a better deal out of state. Often however, the best deal is in your home state because 34 states currently provide state income tax deductions or a tax credit to the contributions made into the state’s own 529 plan.
Shopping around for the best plan for your family should take into consideration not just the projected growth of the investment, but the fees associated with the plan. A high yield growth will mean nothing if the fees eat a sizable piece of that growth. Direct-sold 529 plans often have lower fees than advisor-sold 529 plans, but expenses can vary. It’s important to research your options and find a low-cost 529 plan option that meets your college savings needs.
Types of 529 Plans
There are two main types of 529 plan accounts. The most commonly opened are individual accounts with custodial accounts being less common.
Individual accounts can be opened by a parent (or grandparent) with a child named as the beneficiary. Anyone can contribute to a parent owned 529 plan. Families may even request 529 contributions in lieu of birthday gifts for their child, involving the extended family in saving for a child’s education. Typically, only one parent is the account owner. If the child’s parents are divorced, the account owner should be the parent who will be responsible for filing the FAFSA application when the child goes to college. It is usually best if a biological parent is the owner of the account rather than a stepparent.
Custodial 529 plans have the child as both the account owner and the beneficiary. Since the child is a minor, a custodian will manage the account on behalf of the child until the child reaches the age of majority. A custodial account is less flexible because the beneficiary cannot be changed. This can complicate matters if a child does not attend college or have other educational fees that qualify.
When Grandparents open a 529
If a child’s grandparents open a 529 account with themselves as the account owner and the grandchild as the beneficiary, it can hurt the grandchild’s eligibility for need-based financial aid. Initially, a grandparent-owned 529 plan is not reported as an asset on the FAFSA application; however, distributions from a grandparent-owned 529 plan count as untaxed income to the grandchild on the next year’s FAFSA. This can reduce the child’s aid eligibility for that year. One way to get around this is to have the grandparent owned 529-account pay for the latter years of college. In this way, the untaxed income is not a factor on the financial aid application because the student will be graduating.
Limits of giving
There are no annual contribution limits for a 529 plan as there are for a 401K for example. Parents can give up to $15,000 or $30,000 as a couple, each year without incurring a gift tax. The gift tax can be avoided by applying a 5 year gift tax average. You can gift up to 5 times the annual amount in a single year provided you make no other gifts during the next 5 years.
Choosing 529 Investments
Usually the number of investment options for a 529 is limited, but it’s still a good idea to take a closer look at what you are investing in. The most common 529 investment strategy is an age-based portfolio, which starts off with an aggressive mix of investments and gradually shifts to a less risky mix of investments as the child approaches college age. You can change your investment strategy twice a year.
Read more: Tips for Paying For College
Changing the beneficiary
You may need to change the beneficiary from one child to another if, for example, a child doesn’t attend college or uses all of their fund on their own education. The fund beneficiary can be changed to a qualifying family member. There are no tax consequences if the new beneficiary is either a sibling, step-sibling, foster or adopted child, niece/nephew, uncle/aunt, first cousin, or ‘in-law’ such as a son-in-law, sister-in-law etc. To change the beneficiary you’ll need to apply through the account manager and company.
If you wish to transfer funds from one child to another and they each have their own 529 plans, you could rollover one account into the other. Check with your account manager for any limitations to the rollover. The IRS allows one tax-free rollover in a 12-month period.
529 Plan and Financial Aid
A parent owned 529 plan is considered an asset when applying for financial aid through the FAFSA. This may mean your child could receive less financial aid than you might otherwise had qualified. However, a parent owned 529 account is viewed more favorably on the FAFSA than a custodial account. Furthermore, any distributions from a parent owned 529 account are not counted as income on the FAFSA application.
An alternative to a 529 plan could be a Roth IRA, which is not considered in a financial aid application. Roth IRAs are more flexible than 529 plans, and while they don’t receive the same tax deductions, they can be used for education and retirement alike. You may also consider using a Roth IRA if you live in a state that doesn’t give a tax break on 529 contributions.
Unqualified 529 plan withdrawals
There is a 10% penalty on the earnings if you withdraw funds from a 529 plan and use it for something other than educational purposes. You will also be required to pay tax on the fund’s earnings as well. This is something to consider if your child doesn’t go to college.
Other uses for a 529 plan
If a child doesn’t go to college, you can use the funds to pay off student debt, pay for K-12 education, or pay for a US Department of Labor registered apprenticeship for another qualifying family member.
If none of these options apply to your family, the fund can be cashed out after paying the penalty and used in any way you see fit. It can be used to establish a new business, buy a home, or any other use.
Lori Stratford is the Digital Media Manager at Navicore Solutions. She promotes the reach of Navicore’s financial education to the public through social media and blog content.