With the birth of my twins last month (picture shown) it was time to for me to make sure that I follow the same advice we give our clients. My wife and I immediately started looking into Section 529 savings plans. We were able to establish one plan for each of our children and start ongoing automatic monthly contributions. Who knows how much college will cost in the future but we've got a head start!
For those that have started this process, considering the many different 529 plans can be daunting. In this blog I wanted to review:
- General features of 529 savings plans
- How to choose an appropriate 529 plan, and
- Tips for how to select the investment options.
529 savings plans are college-savings accounts that typically offer a menu of stock and bond mutual fund investment options. 529 plans can be attractive college funding options because of their current federal income-tax-free status and, for some plans, the potential for state tax deductions or credits. Investors can generally contribute to any state’s plan, although state tax deductions may not apply to out-of-state investors and some states require the account owner or beneficiary to be a state resident to participate. Investors will find that the quality of 529 plans varies widely from state to state. Some states’ plans are loaded with high-cost, low-quality investment options, while others offer low-cost passively managed options. Not all 529 plans were created equally. Therefore, you should consider expense ratios, other fees and investment options when evaluating plans.
529 PLAN BASICS
Here are some general facts about 529 college savings plans:
- Individuals contribute after-tax dollars that grow tax free, such as they do in a Roth IRA.
- Anyone can act as the owner of the plan and name a child or grandchild (or anyone else including themselves) as the beneficiary.
- A parent or grandparent can contribute to any state’s plan, but some states allow residents to claim a state-tax deduction for all or a portion of 529 contributions. Some states require the account owner or beneficiary to be a state resident to participate.
- You are restricted to the investment options within a state’s plan.
- The owner (and not the beneficiary) retains control of the 529 assets.
- 529 earnings can be withdrawn free of federal taxes for qualified education expenses (see below for more details). If 529 earnings are withdrawn for non-qualified expenses, they will be subject to income tax and a 10% penalty.
- 529 plan assets are not treated as a child’s personal assets for federal financial aid purposes, even if the account is owned by the child. However, 529 plan assets are treated as a parental asset (even if it is owned by the child). The bottom line is 529 assets do affect financial aid eligibility, just not as much as if they were considered the student’s personal asset.
A 529 account can be used to pay for expenses that are related to college or other post-secondary training institutions. Tuition and room and board are qualified expenses. However, room and board costs have limits and the student must be enrolled in an eligible college at least half-time. If the student is living on-campus, their qualified room and board costs will be equal to the actual invoice amount they are charged for housing owned or operated by the college. If the student is living off-campus, qualified room and board costs must be less than or equal to what is included in the college’s cost of attendance for federal aid calculations.
Textbooks are also qualified, but only those included on the required reading list for the course. In addition, required supplies, equipment, computer, internet access and special needs equipment are qualified. Federal law allows all 529 plans to be used for private K-12 tuition up to $10,000 per year per beneficiary. But many states have not adjusted their laws to comply with federal law. In those states, using a 529 for K-12 tuition would be non-qualified. Federal law also allows 529 plans to be used for qualified apprenticeship-related expenses and qualified student loan repayment, but again many states have not adjusted their laws accordingly.
THREE STEPS TO TAKE WHEN CHOOSING AN APPROPRIATE 529 PLAN
Even amidst an ever-changing 529 plan landscape, the following steps should assist you in making appropriate selections based on your particular situation. We consider the following factors most critical to the decision-making process when balanced against each other:
- What are the plan’s investment options? Find the plans that allow for the most effective global diversification — and preferably are passively managed.
- What are the plan’s costs? The lower the costs, the less returns will be significantly eroded by fees.
- What are the plan’s tax benefits to the account owner?
While we do not believe investors should automatically choose their own state’s 529 plan without thorough investigation, enjoying both federal and state tax advantages can be an important deciding factor. Following are three steps you can implement to assess the above critical factors as well as other components that contribute to your final decision.
Step 1: Consider the your state of residency.
Begin by assessing your own state’s plan, if it offers any state tax benefits for contributions. In addition, consider the following questions:
- Are the plan’s expenses reasonable?
- If you were to move to a different state, is the plan flexible? (Some 529 plans dictate that, if the individual transfers assets out of his or her state of residence and into another state’s plan, 529 distributions may be taxed by the state of residence and/or past tax benefits may be subject to recapture.)
- How are the plan’s funds allocated? It is possible that you might rule out a 529 plan that meets all but one of the above requirements. For example, a plan might offer state tax savings and be flexible, but it also charges an excessive expense ratio or has suboptimal investment options. Thus, if your state option isn’t the best choice, it’s time to move to Step 2.
Step 2: Consider state plans that offer passively managed and/or low-cost funds
Plans like Utah's Education Savings Plan (UESP) and West Virginia's Smart529 Select have ranked well recently for their low cost investment options. New York's 529 College Savings Plan has low cost investments available through Vanguard while Fidelity-managed 529 plans available in New Hampshire, Arizona, Connecticut, Delaware and Massachusetts have some low cost index options. To research state plan's you can use https://www.savingforcollege.com/ to help you with your search.
Step 3: Check that you are using an appropriate asset allocation within the 529 plan and rebalance accordingly
An easy place to start is the age based programs that will automatically choose an allocation for you and get more conservative as your child gets closer to college. Although this sounds like a perfect solution it is typically not optimal for everyone since they are market neutral. We generally recommend that you want to utilize the academic research to allocate your investments and tilt towards areas of the market that may give higher expected returns over the long-term.
Even with a constantly evolving 529 plan landscape, some plans compare favorably with just saving in a taxable account that has fewer restrictions. Low-cost, high-quality 529 plans offer families a good option for at least a portion of their college savings. At the same time, it remains prudent to investigate all alternatives before investing in a particular 529 plan.
Three primary factors to weigh are:
- The value of the tax benefits in your home state's plan
- The costs of the plan, and
- The extent to which a plan offers passively managed, globally diversified investment options.
It may make sense to get counsel before making these decisions so feel free to consult us if we can help you in selection of a plan!
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