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Part 2: Paying for College

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Today we are going to be talking about 529 plans. As you may recall from last week’s post (Part 1: Paying for College) we talked about some important terminology and one of those terms was the EFC, the Expected Family Contribution as determined by the FAFSA. This is the amount that your family is expected to be able to contribute towards the cost of college. We also spoke about the term gapping and this is difference between the net price (not the sticker price we spoke about) but the net price and the EFC. This gapping amount is where students often need to obtain a loan if a family doesn’t have funds to cover it. A 529 savings plan is a great way to be saving funds to put towards both the EFC and potential gapping.

So what exactly is a 529 plan?

A 529 plan is a qualified tuition plan that is a tax-advantaged savings plan to save for future education costs. There are two types: a prepaid tuition plan and an education savings plan. The education savings plan is the more common and is the one we are focusing on here. It works similar to a Roth IRA in that you invest after-tax dollars and the investment grows tax-deferred and the withdrawals are tax free if used for qualified education expenses.

529 plans are sponsored by the states. There is at least one plan sponsored in every state. That means the state determines the rules and the limits for the plan. However, most plans do not have a residency requirement, meaning you do not have to be a resident of the state plan you choose. If you are interested in a plan from a state other than your state of residency, be sure to confirm the residency requirements. Just because the states sponsor these plans, it does not mean they guarantee their plans. As with most investments, there is a level of risk. Most portfolio options include mutual funds and/or ETFs (exchange traded funds). However, there are plans with products that are FDIC insured. You want to choose a plan that is in line with your risk level. There are also age-based portfolios that become more conservative as they approach the age of withdrawal to limit market type disruptions to the portfolio.

529 plans have pre-set investment options that you choose from. There is the ability to change the investment option but there is a limit on how often that can be done. As with most investment accounts there are fees associated with these plans so be sure to review the fee structure.

Time is your friend when it comes to investing so start as early as you can!

There are many plans that can be opened with as low as a $25 contribution and then additional contributions can be made as often as desired. While there are not limits on the annual contributions to a 529 plan, they are considered gifts in regards to the annual gift tax exclusion which is currently $17,000 a year in 2023. A 529 plan contribution can be a great option for relatives and friends that want to give to your child. (Think about the grandparents giving less toys and more 529 contributions at Christmas!) Grandparents can own the 529 plan but under current law it is generally more beneficial for the parents to own the plan. I will cover that more in just a minute. One other important thing to remember is that the 529 plan can only have one beneficiary. So if you have multiple children you will need a plan for each one as the beneficiary of that plan.

Let’s move on to what the plan covers.

What is a qualified education expense that can be withdrawn tax free? A qualified education expense under a 529 plan includes tuition and fees, room and board, books, supplies, and equipment. Tuition does include up to $10,000 a year for a K-12 school, not just a college or university. Qualified expenses do not include transportation or health insurance. Expenses must be withdrawn in the same year incurred so you can’t take a withdrawal in December for tuition due and paid in January.

Qualified education expense withdrawals are not subject to federal income tax (and in most states not subject to state income tax), but what are other tax implications of a 529 plan? This can depend on the state and 529 plan chosen so again understand the plan thoroughly before you commit to it. It may be worth consulting your tax accountant before choosing a plan. Some states do allow tax deductions on your state income tax return for contributions to a 529 plan. Depending on your state of residence and the plan you choose, you may be eligible for these deductions. Your tax professional can answer these questions depending on where you live.

What if withdrawals are made that are not for qualified education expenses? Withdrawals that are not for qualified education expenses are subjected to a 10% penalty as well as federal and state income tax. The penalty and tax is assessed on the earnings portion of the withdrawal not the full withdrawal. For example, if you had contributed $10,000 and the plan had grown to $15,000 and you withdrew the entire amount, only the $5,000 would be subjected to the penalty and tax. Also note that there are a few exceptions that the 10% penalty is waived.

What if my child doesn’t go to college or doesn’t use all of the funds in a 529 plan? You can change the beneficiary and the funds can be used for another child, grandchild, etc. You can also make yourself the beneficiary if you desire to go back to school. Beginning in 2024, you can rollover up to $35,000 from a 529 plan into a Roth IRA. Note there are some requirements for this such as length of time the 529 plan has been opened but they are not overly stringent or complex. This rollover is a great way to start a retirement plan for your child if the funds are not used for college.

Will a 529 plan affect the FAFSA and financial aid eligibility? Currently if someone owns the 529 plan other than the student or the custodial parent, that 529 plan could negatively impact financial aid eligibility more than one owned by the student or custodial parent. However, there is a new simplified FAFSA rolling out for 2024-2025 that will create changes that are more favorable to someone else such as a grandparent owning the 529 plan. The new FAFSA will also replace the term EFC (the Expected Family Contribution) with the term SAI (Student Aid Index). While the formula for the SAI is similar to that of the current EFC it is important to note that families with multiple children in college at the same time will be treated differently. This change especially could negatively affect middle and high income earners in their calculation. So, a 529 plan may be a good option for families that fall into this category.

All in all, a 529 plan can be a great option for a lot of families but it is something that you need to do your homework on before committing to it. There are a lot of plans to choose from so you want to make sure you decide on the one that is most in line with your risk level and goals. The average cost of college tuition has risen over 179% in the last 20 years (! Start planning for college when your children are young! Let time be on your side while the plan is growing. There are simple ways to fund your plan each month and of course let the grandparents and other relatives know about it. Student loan debt is a huge burden on young adults graduating from college. Early planning and saving can greatly reduce and maybe even eliminate the need for student loans!

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