College Savings
By Megan Breslin
April 29, 2022
In the fall semester of 2020 (the most recent available data through the Education Data Initiative), roughly 15.9 million undergraduate students were enrolled in American universities or colleges. Though there have been slight declines in enrollment over the past couple of years, millions of students will continue to pursue postsecondary education in the coming years. Sound financial college planning is so important and understanding best practices for doing so will help you make the best decisions.
It’s widely understood that college is an investment of both time and money. College costs tend to increase at approximately two times the annual rate of inflation, which is expected to persist for the foreseeable future. Planning ahead for your kids’ or grandchildren’s education is a wise investment choice. There are several ways to do so.
A 529 plan tops the list of smart ways to budget for college. 529s can be used for a myriad of educational purposes and expenses including tuition, student activity fees required to attend a given institution, and student loan payments once an individual has graduated. As the account matures, the earnings from contributed funds grow tax-free. The distributions are not taxed, either, as long as the funds are used for qualified higher education expenses. It’s important to understand, however, that any funds taken from a 529 plan that are not used for educational expenses are subject to income tax and can incur a 10% penalty. Some states may also impose their own penalties. It’s also important to note that using a 529 for K-12 tuition does not always follow the same higher education tax preferences. That is determined on a state-by-state basis. For example, using a 529 account to pay tuition for K-12 students in California is not considered a qualified distribution. Because of this, the funds withdrawn are subject to state income tax and will also trigger a 2.5% penalty tax.
Typically, there are two forms of 529 plans: college savings plans and prepaid tuition plans. The former functions similarly to other retirement plans—401(k)s or IRAs, specifically—in that your contributions are invested in mutual funds or comparable investments. College savings plan earnings are based on market performance and usually have age-based investment options which become more conservative as the college-bound beneficiary nears college entrance.
Prepaid tuition plans, sometimes called guaranteed savings plans, allow investors to lock in the current tuition rate by prepurchasing tuition for their beneficiary. This plan can only be administered at the state level; thus, if a college-bound student goes out of state or to a private school, the balance of the account can be refunded or transferred. Only a limited number of states offer prepaid tuition 529 plans. If your state does not offer a state-specific plan, you can elect to open a 529 from any state. If your state does offer a state-specific plan, you may be eligible for a state deduction.
529 plans have additional benefits, as well. Surplus funds can be transferred to a sibling, cousin, or can be returned to you. You can also open a 529 plan with a very limited amount of money. There are, of course, also drawbacks. Having a 529 will affect any potential financial aid package a student will receive; however, this may not be terribly detrimental depending upon your personal circumstances. When determining your child’s Expected Family Contribution (EFC), the formula used to determine financial aid, the percentage of parents’ assets that’ll be counted to pay for college expenses is presently capped at 5.64%. The tax-free investment gains you’ve earned could likely outweigh this.
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