Saving for College

For College Savings, 529 Plans Are Hard to Beat

Raising kids is hard enough, so why not make things easier for yourself when it comes to saving for college? Ideally, you want a savings vehicle that doesn't impose arbitrary income limits on eligibility; lets you contribute a little or a lot, depending on what else happens to be going on financially in your life at the moment; lets you set up automatic, recurring contributions from your checking account so you can put your savings effort on autopilot; and offers the potential to stay ahead of college inflation, which has been averaging 3% to 4% per year.1 Oh, and some tax benefits would be really nice, too, so all your available dollars can go to college and not Uncle Sam. Can you find all of these things in one college savings option? Yes, you can: in a 529 plan.

Benefits

529 college savings plans offer a unique combination of features that are hard to beat when it comes to saving for college, so it's no surprise why assets in these plans have grown steadily since their creation over 20 years ago.

Eligibility. People of all income levels can contribute to a 529 plan - there are no restrictions based on income (unlike Coverdell accounts, U.S. savings bonds, and Roth IRAs).

Ease of opening and managing account. It's relatively easy to open a 529 account, set up automatic monthly contributions, and manage your account online. For example, you can increase or decrease the amount and frequency of your contributions (e.g., monthly, quarterly), change the beneficiary, change your investment options, and track your investment returns nd overall progress online with the click of a mouse.

Contributions. 529 plans have high lifetime contribution limits, generally $350,000 and up. (529 plans are offered by individual states, and the exact limit depends on the state.) Also, 529 plans offer a unique gifting feature that allows lump-sum gifts up to five times the annual gift tax exclusion - in 2020, this amount is up to $75,000 for individual gifts and up to $150,000 for joint gifts - with the potential to avoid gift tax if certain requirements are met. This can be a very useful estate planning tool for grandparents who want to help pay for their grandchildren's college education in a tax-efficient manner.

Tax benefits. The main benefit of 529 plans is the tax treatment of contributions. First, as you save money in a 529 college savings plan (hopefully every month!), any earnings are tax deferred, which means you don't pay taxes on the earnings each year as you would with a regular investment account. Then, at college time, any funds used to pay the beneficiary's qualified education expenses - including tuition, fees, room, board, books, and a computer - are completely tax-free at the federal level. This means every dollar is available for college. States generally follow this tax treatment, and many states also offer an income tax deduction for 529 plan contributions.

Drawbacks

But 529 plans have some potential drawbacks.

Tax implications for funds not used for qualified expenses. If you use 529 plans funds for any reason other than the beneficiary's qualified education expenses, earnings are subject to income tax (at your rate) and a 10% federal penalty tax.

Restricted ability to change investment options on existing contributions. When you open a 529 college savings plan account, you're limited to the investment options offered by the plan. Most plans offer a range of static and age-based portfolios (where the underlying investments automatically become more conservative as the beneficiary gets closer to college) with different levels of risk, fees, and management objectives. If you're unhappy with the market performance of the option(s) you've chosen, you can generally change the investment options for your future contributions at any time. But under federal law, you can change the options for your existing contributions only twice per year. This rule may restrict your ability to respond to changing market contributions, so you'll need to consider any investment changes carefully.

Getting started

529 college savings plans are offered by individual states (but managed by financial institutions selected by the state), and you can join any state's plan. To open an account, select a plan and complete an application, where you will name an account owner (typically a parent or grandparent) and beneficiary (there can be only one); choose your investment options; and set up automatic contributions if you choose. You are then ready to go. It's common to open an account with your own state's 529 plan, but there may be reasons to consider another state's plan; for example, the reputation of the financial institution managing the plan, the plan's investment options, historical investment performance, fees, customer service, website usability, and so on. You can research state plans at the College Savings Plans Network.

1  College Board, Trends in College Pricing, 2014-2018

When should I file the FAFSA?
 

The FAFSA, which stands for Free Application for Federal Student Aid, is  federal government's financial aid application. The FAFSA is a prerequisite for federal student loans, grants, and work-study. In addition, colleges typically require the FAFSA before distributing their own need-based aid and, in some cases, merit-based aid. 

For the 2020-2021 school year, the FAFSA can be filed as early as October 1, 2019. Whether you have a senior in high school or a returning college student, it's a good idea to file the FAFSA as early as possible to increase your child's chances of getting financial aid, because some aid programs operate on a first-come, first-served basis. (For high school seniors who haven't yet been accepted at a particular college, you can list all the schools your child has applied to on the form.)
 
The 2020-2021 FAFSA relies on your family's current asset information and two-year-old income information from your 2018 tax return. The form is available online at fafsa.ed.gov.
 
In order to file the form, you'll need to create an FSA ID if you haven't done so already (be sure to follow the online instructions). You can save time and minimize errors on the FAFSA by using the built-in IRS Data Retrieval Tool, which electronically imports your tax data.
 
Even if you don't expect your child to qualify for need-based aid, you still might consider submitting the FAFSA. All students attending college at least half-time are eligible for federal unsubsidized Direct Loans regardless of financial need. So if you want your child to take out a loan (or your child needs to do so), you'll need to file the FAFSA. (Unsubsidized Direct Loan amounts are capped each year: $5,500 freshman year, $6,500 sophomore year, and $7,500 junior and senior years.)
 
Keep in mind that you'll need to resubmit the FAFSA each year that you want your child to be considered for aid. Fortunately, renewal FAFSAs take less time to complete.

What's New in the College World?

If you're the parent or grandparent of a current or prospective college student, you might be interested to learn what's new in the world of higher education. 

Higher college costs
 
For the 2018-2019 school year, average costs for tuition, fees, room, and board were:

• $21,370 at public colleges (in-state)
• $37,430 at public colleges (out-of-state)
• $48,510 at private colleges

The following table shows the average annual percentage increase for tuition, fees, room, and board since 2015.1 Despite steady cuts to their budgets from state legislatures, public colleges have been doing a better job of holding down cost increases than private colleges.

Assuming a 3% across-the-board increase, average costs for 2019-2020 would be:

• $22,011 at public colleges (in-state)
• $38,552 at public colleges (out-of-state)
• $49,965 at private colleges

Keep in mind that these figures are averages; many colleges cost substantially more. And these figures don't include cost for books, supplies, personal expenses, or transportation, which can add on a few thousand dollars. If you're a parent and cost is a factor when looking at colleges, you need to take the lead in the conversation because most 16-, 17-, and 18-year-olds are not financially savvy enough to drive a $100,000 or $200,000 decision.
 
Higher student debt
 
Speaking of costs, about 65% of U.S. college seniors who graduated in 2017 had student loan debt, owing an average of $28,650.2 And it's not just students who are borrowing. Parents are borrowing, too. There are approximately 15 million student loan borrowers age 40 and older, and this demographic accounts for almost 40% of all student loan debt.3 Student loan debt is now the second-highest consumer debt category after mortgage debt, ahead of both credit card and auto loans.4
 
Reduced asset protection allowance
 
Behind the scenes, a stealth change in the federal government's financial aid formula has been quietly (and negatively) impacting families. The asset protection allowance, which lets parents shield a certain amount of their non-retirement assets from consideration, has been steadily declining for years, resulting in a higher expected family contribution, or EFC. Ten years ago, in the 2008-2009 school year, the asset protection allowance for a 48-year-old married parent was $46,700. In 2018-2019, that same allowance was $21,300, resulting in  $1,432 decrease in a student's aid eligibility ($25,400 x 5.64%, the federal contribution percentage required from parent assets).5
 
FAFSA timeline
 
The FAFSA (Free Application for Federal Student Aid) for the 2020-2021 school year can be filed starting October 1, 2019, and relies on information in your 2018 federal income tax return.
 
Proposed 529 plan changes
 
In April 2019, the House Ways and Means Committee passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act, which focuses primarily on changes to retirement plans but also includes the expansion of 529 plans.6 Under the proposed legislation, 529 plan qualified expenses would be expanded to include:

• Apprenticeship programs
• Up to $10,000 (lifetime cap) toward student loan repayment
   

The legislation has broad bipartisan support, so look for progress in 2019.
 
Recent college admissions scandal
 
Finally, a little perspective. The recent college admissions scandal has put a spotlight on the frenzy surrounding elite college admissions and perpetuates the notion that a child's attendance at a particular school is a make-or-break, life-defining moment. But families shouldn't buy into this narrative. Reach for the best schools? Sure, if that's important to you and your child. Think your child's life is over if he or she doesn't get into one of these schools? No. Many colleges provide an excellent education, and it's up to students to make the most of the opportunities available wherever they land.
 
1 College Board, Trends in College Pricing, 2015-2018
2 The Institute for College Access and Success, Student Debt and he Class of 2017, September 2018
3 Federal Reserve Bank of New York, Student Loan Data and Demographics, September 2018
4 Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, August 2018
5 U.S. Department of Education, EFC Formula, 2008-2009, 2018-2019
6 savingforcollege.com, April 12, 2019

How much money should a family borrow for college?

There is no magic formula to determine how much you or your child should borrow for college. But there is such a thing as borrowing too much. How much is too much? One guideline is for students to borrow no more than their expected first-year starting salary after college, which, in turn, depends on a  student's particular major and/or job prospects. 

But this guideline is simply that - a guideline. Just as many homeowners got burned in the housing crisis by taking out larger mortgages than they could afford, families can get burned by borrowing amounts for college that seemed reasonable at the time but now, in hindsight, are not.
 
Keep in mind that student loans will need to be paid back over a term of 10 years (possibly longer). A lot can happen during that time. What if a student's assumptions about future earnings don't pan out? Will student loans still be manageable when other expenses like rent, utilities, and/or can expenses come into play? What if a borrower steps out of the workforce for an extended period of time to care for children and isn't earning an income? There are many variables, and every student's situation is different. A loan deferment is available in certain situations, but postponing loan payments only kicks the can down the road.
 
To build in room for the unexpected, a smarter strategy may be for undergraduate students to borrow no more than the federal student loan limit, which is currently $27,000 for four years of college. Over a 10-year term with a 5.05% interest rate (the current 2018-2019 rate on federal Direct Loans), this equals a monthly payment of $287. If a student borrows more by adding in co-signed private loans, the monthly payment will jump, for example, to $425  for $40,000 in loans (at the same interest rate) and to $638 for $60,000 in loans. Before borrowing any amount, students should know exactly what their monthly payment will be. And remember: Only federal student loans offer income-based repayment (IBR) options.
 
As for parents, there is no one-size-fits-all rule on how much to borrow. Many factors come into play, including the number of children in the family, total household income and assets, and current and projected retirement savings. The overall goal, though, is to borrow as little as possible.

Rules on Opening a 529 Plan Account for College

Year over year, participation in 529 plans continue to rise.1 Anyone can open an account, lifetime contribution limits are typically over $300,000, and there are tax benefits if the funds are used for college. Here are some common questions on opening an account. 

Can I open an account in any state's 529 plan or am I limited to my own state's plan?
 
Answer: It depends on the type of 529 plan you have: college savings plan or prepaid tuition plan. With a college savings plan, you open an individual investment account and direct your contributions to one or more of the plan's investment portfolios. With a prepaid tuition plan, you purchase education credits at today's prices and redeem them in the future for college tuition. Forty-nine states (all but Wyoming) offer one or more college savings plans, but only a few states offer prepaid tuition plans.
 
529 college savings plans are typically available to residents of any state, and funds can be used at any accredited college in the United States or abroad. But 529 prepaid tuition plans are typically limited to state residents and apply to in-state public colleges.
 
Why might you decide to open an account in another state's 529 college savings plan? The other plan might offer better investment options, lower management fees, a stronger investment track record, or better customer service. If you decide to go this route, keep in mind that some states may limit certain 529 plan tax benefits, such as a state income tax deduction for contributions, to residents who join the in-state plan.
 
Is there an age limit on who can be a beneficiary of a 529 account?
 
Answer: There is no beneficiary age limit specified in Section 529 of the Internal Revenue Code, but some states may impose one. You'll need to the check the rules of each plan you're considering. Also, some states may require that the account be in place for a specified minimum length of time before funds can be withdrawn. This is important if you expect to make withdrawals quickly because the beneficiary is close to college age.
 
Can more than one 529 account be opened for the same child?
 
Answer: Yes. You (or anyone else) can open multiple 529 accounts for the same beneficiary, as long as you do so under different 529 plans 9college savings plan or prepaid tuition plan). For example, you could open a college savings plan account with State A and State B for the same beneficiary, or you could open a college savings plan account and a prepaid tuition plan account with State A for the same beneficiary. But you can't open two college savings plan accounts in the same 529 plan in State A for the same beneficiary.
 
Also keep in mind that if you do open multiple 529 accounts for the same beneficiary, each plan has its own lifetime contribution limit, and conditions can't be made after the limit is reached. Some states consider the accounts in other states to determine whether the limit has been reached. For these states, the total balance of all plans (in all states) cannot exceed the maximum lifetime contribution limit.
 
Can I open a 529 account in anticipation of my future grandchild?
 
Answer: Technically, no, because the beneficiary must have a Social Security number. But you can do so in a roundabout way. First, you'll need to open an account and name as the beneficiary a family member who will be related to your future grandchild. Then when your grandchild is born, you (the account owner) can change the beneficiary to your grandchild. Check the details carefully of any plan you're considering because some plans may impose age restrictions on the beneficiary, such as being under ag 21. This may pose a problem if you plan to name your adult son or daughter as the initial beneficiary.
 
What happens if I open a 529 plan in one state then then move to another state?
 
Answer: Essentially, nothing happens if you have a college savings plan. But most prepaid tuition plans require that either the account owner or the beneficiary be a resident of the state operating the plan. So if you move to another state, you may have to cash in the prepaid tuition plan.
 
If you have a college savings plan, you can simply leave the account open and keep contributing to it. Alternatively, you can switch 529 plans by rolling over the assets from the plan to a new 529 plan. You can keep the same beneficiary when you do the rollover (under IRS rules, you're allowed one 529 plan same-beneficiary rollover once every 12 months), but check the details of each plan for any potential restrictions. If you decide to stay with your original 529 plan, just remember that your new state might limit any potential 529 plan tax benefits to residents who participate in the in-state plan.
 
1 Strategic Insight, 529 Data Highlights, 3Q 2018

What's so great about a college net price calculator?

If you're saving for a child's college education, at some point you'll want to familiarize yourself with a college net price calculator, which is an invaluable tool for estimating financial aid and measuring a college's affordability. Available on every college website, a net price calculator gives families an estimate of how much grant aid a student might expect at a particular college based on his or her personal financial and academic profile and the college's specific criteria for awarding grant aid. A college's sticker price minus grant aid equals a family's "net" price, hence the name.
 
The idea behind a net price calculator is to give families who are researching colleges a more accurate picture of what their out-of-pocket costs are likely to be, rather than having them rely on a college's published sticker price. The figures quoted by a net price calculator aren't guarantees of grant aid, but the estimates are meant to be close, so running the numbers is an excellent way for parents to see what their net price might be at different colleges.
 
Keep in mind that each college has a different sticker price and formula for determining how much grant aid it distributes, so every calculator result will be different. For example, after entering identical financial and family information on three separate net price calculators, you might find that College A has a net price of $25,000 per year, College B has a net price of $30,000, and College C is $40,000.
 
A net price calculator typically asks for the following information: parent income and assets, student income and assets, and the number of children in the family, including how many will be in college at the same time. (Generally, the more children in college at the same time, the more grant aid.) It may also ask more detailed questions, such as a student's class rank and/or text scores, how much money parents have saved in employer retirement plans in the most recent tax year, current home equity, and how much parents expect to pay in healthcare costs in the coming year.
 
A net price calculator typically takes about 10-15 minutes to complete and is time well spent. Typing "net price calculator" in the search bar of a college's website should direct you to it.

College Saving: How Does a 529 Plan Compare to a Roth IRA?

529 plans were created 22 years ago, in 1996, to give people a tax-advantaged way to save for college. Roth IRAs were created a year later, in 1997, to give people a tax-advantaged way to save for retirement. But a funny thing happened along the way - some parents adapted the Roth IRA as a college savings tool. 

Tax benefits and use of funds
 
Roth IRAs and 529 plans have a similar tax modus operandi. Both are funded with after-tax dollars, contributions accumulate tax deferred, and qualified distributions are tax-free. But in order for a 529 plan distribution to be tax-free, the funds must be used for college or K-12 education expenses. By contrast, a qualified Roth distribution can be used for anything - retirement, college, travel, home remodeling, and so on.
 
In order for a distribution from a Roth IRA to be tax-free (i.e., a qualified distribution), a five-year holding period must be met and one of the following must be satisfied: The distribution must be made (1) after age 59 1/2, (2) due to a qualifying disability, (3) to pay certain first-time homebuyer expenses, or (4) by your beneficiary after your death.
 
For purposes of this discussion, it's the first condition that matters: whether you will be 59 1/2 or older when your child is in college. If the answer is yes (and you've met the five-year holding requirement), then your distribution will be qualified and you can use your Roth dollars to pay for college with no tax implications or penalties. If you child ends up getting a grant or scholarship, or if overall college costs are less than you expected, you can put those Roth dollars toward something else.
 
But what if you'll be younger than 59 1/2 when your child is in college? Can you still use Roth dollars? You can, but your distribution will not be qualified. This means that the earnings portion of your distribution (but not the contributions portion) will be subject to income tax. (Note: Just because the earnings portion is subject to income tax, however doesn't mean you'll necessarily have to pay it. Nonqualified distributions from a Roth IRA draw out contributions first and then earnings, so you could theoretically withdraw up to the amount of your contributions and not owe income tax.)
 
Also, if you use Roth dollars to pay for college, the 10% early withdrawal penalty that normally applies to distributions before age 59 1/2 is waived. So the bottom line is, if you'll be younger than 59 1/2 when your child is in college and you use Roth dollars to pay college expenses, you might owe income tax (on the earnings portion of the distribution), but you won't owe a penalty.
 
If 529 plan funds are used for any other purpose besides the beneficiary's qualified education expenses, the earnings portion of the distribution is subject to income tax and a 10% federal tax penalty.
 
Financial aid treatment
 
At college time, retirement assets aren't counted by the federal or college financial aid formulas. So Roth IRA balances will not affect financial aid in any way. (Note: Though the aid formulas don't ask for retirement plan balances, they typically do ask how much you contributed to your retirement accounts in the past year, and colleges may expect you to apply some of those funds to college.)
 
By contrast, 529 plans do count as an asset under both federal and college aid formulas. (Note: Only parent-owned 529 accounts do not, but withdrawals from these accounts are counted as student income.)
 
Investment choices
 
With a Roth IRA, your investment choices are virtually unlimited - you can hold mutual funds, individual stocks and bonds, exchange-traded funds, and REITs, to name a few.
 
With a 529 plan, you are limited to the investment options offered by the plan, which are typically a range of static and age based mutual fund portfolios that vary in their level of risk. If you're unhappy with the market performance of the options you've chosen, under federal law you can change the investment options for your existing contributions only twice per calendar year (though you can generally change the investment options on your future contributions at any time).
 
Eligibility and contribution amounts
 
Unfortunately, not everyone is eligible to contribute to a Roth IRA. For example, your income must be below a certain threshold to make the maximum annual contribution of $5,500 (or $6,500 for individuals age 50 and older).
 
By contrast, anyone can contribute to a 529 plan; there are no restrictions based on income. Another significant advantage is that lifetime contribution limits are high, typically $300,000 and up. And 529 plan rules allow for large lump-sum, tax-free gifts if certain conditions are met - $75,000 for single filers and $150,000 for married joint filers in 2018, which is equal to five years' worth of the $15,000 annual gift tax exclusion.

How can families trim college costs?

Trimming college costs up front can help families avoid excessive college borrowing and the burdensome student loan payments that come with it. Here at some ideas.
 
1. Pick a college with a lower net price. You can use a college's net price calculator (available on every college's website) to estimate what your net price (out-of-pocket cost) will be at individual colleges. A net price calculator does this by estimating how much grant aid a student is likely to receive based on a family's financial and personal information. Colleges differ on their aid generosity, so after entering identical information in different calculators, you may find that College A's net price is $35,000 per year while College B's net price is $22,000. By establishing an ideal net price range, your child can target schools that hit your affordable zone.
 
2. Investigate in-state universities. Research in-state options and encourage your child to apply to at least one in-state school. In-state schools generally offer the lowest sticker price (though not necessarily the lowest net price) and may offer scholarships to state residents.
 
3. Research colleges that offer generous merit aid. All colleges are not created equal in terms of how much institutional aid they offer. Spend time researching colleges that offer generous merit aid to students whose academic profile your child matches.
 
4. Graduate early. Earn college credit in high school by taking AP/IB classes and then graduate a semester or two early. Or look at colleges that specifically offer three-year accelerated degree programs.
 
5. Seek out free room and board. There are two ways to do this: The first is to live at home (though transportation costs might eat into your savings), and the second way is to become a resident assistant (RA) on campus, a job that typically offers free room and board.
 
6. Work during college. Working during college and contributing modest amounts to tuition along the way - say $1,500 to $3,000 a year - can help students avoid another $6,000 to $12,000 in loans.
 
7. Combine traditional and online courses. Does the college offer online classes? If so, you may be able to earn some credits at a lower cost over the summer or during breaks.