Debunking the Myths of 529 Plans for College Savers

Like saving for retirement, you can never start too early on saving for college. The cost of post-secondary education continues to outpace inflation. According to FinAid.org (opens in new tab), the historical average college tuition inflation rate was 8%, compared with 3.2% for inflation (opens in new tab). More recently, tuition inflation rates have been hovering around 6% annually and inflation overall is a little over 2%.

College will cost how much?

According to CNBC, Fidelity has a new “$2K” rule of thumb (opens in new tab): If you intend to cover half the cost of college tuition at a four-year public university, multiply your child’s age by $2,000. For example, a 10-year-old should have a 529 savings plan account with $20,000 in it. Obviously, if you intend to send your child to a more expensive school or cover more than half the cost, the target amount should be higher.

The College Board’s 2016 study “Trends in College Pricing” (opens in new tab) indicates the average cost of four-year public in-state college hit $17,100 for the 2016-17 school year. That figure includes undergraduate tuition, room and board. The cost for private school undergrads? An average of $43,440. By 2024, those averages are expected to climb to $34,000 and $76,000, respectively.

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The Struggle

Many of my clients ask a similar question: How should our savings be directed? When there are several competing priorities – emergency fund, paying off debt, saving for retirement, etc. – adding education savings to the list may seem too daunting. Generally, I encourage young families to focus on immediate goals like the emergency fund and debt management. We also look at maximizing any employer match through a company-sponsored retirement plan. THEN, and only THEN, do we explore 529 plan funding.

Two Types of 529 Plans

In the world of 529 college savings plans, there are two primary types: Prepaid and Savings.

Prepaid (opens in new tab) plans are available only in select states and allow you to purchase tuition credits at today’s rates. Since these prepaid plans are administered by the state or higher education institution, investment performance is tied to tuition inflation.

The more common 529 college savings plans are available nationwide and are subdivided into broker and direct plans. Broker-sold plans can be purchased through an investment adviser and are professionally managed by that adviser. Direct plans, on the other hand, are generally less expensive but more of the “DIY” version. You, as the account owner, decide how to allocate investments in direct plans. Many of these state-run savings plans offer age-based options that gradually become more conservative as the beneficiary nears college age. The market performance of any 529 savings plan is tied to the underlying investment.

Debunking the Myths: Take the Quiz

Now that you understand the types of 529 plans, let’s play a game: TRUE or FALSE.

1. True or false: You must invest in the 529 plan of your home state.

FALSE. Several states offer a state income tax deduction only if you invest in your home state plan, but other states provide tax parity whereby you receive the state income tax deduction even if you contribute to an outside state’s plan. Examples of these parity states include Arizona, Kansas, Missouri and Pennsylvania.

2. True or false: You will lose money if your child (the beneficiary) doesn’t go to college.

FALSE. The amount you initially contribute to a 529 plan can be withdrawn without penalty. Only the “gain” or appreciation is subject to income tax and 10% penalty for non-qualified (“NQ”) distributions. Let’s suppose you contributed $50,000 to a 529 plan and the balance grew to $60,000. You pay income tax and 10% penalty on the $10,000 gain of NQ distributions. Furthermore, if your son or daughter will not be attending college, you can transfer 529 funds to another family member without penalty. There is no age or income limit for a beneficiary.

3. True or false: A 529 plan allows you to save for future higher-education costs and simultaneously make a tax-advantaged investment.

TRUE. Contributions to 529 plans grow tax-deferred, and qualified distributions are tax-free. By definition, qualified 529 plan withdrawals include tuition, fees, books, equipment and supplies. Room and board is also considered “qualified” if the student is enrolled at least half-time at a university or vocational school.

4. True or false: Many 529 plans allow out-of-state investors, but other benefits may apply to investors who participate in their state-sponsored plans.

TRUE. Choosing your home state plan may result in matching grants and scholarships, protection from creditors and exemption from state financial aid calculations. If you reside in a parity state, lower fees and superior historical investment performance may entice you to choose an out-of-state plan. Regardless of which state plan you choose, there is a downside: 529 plan balances impact the federal student aid calculation for need-based aid (opens in new tab) and reduce eligibility for select federal tax credits. Assets in accounts owned by a dependent student or one of their parents are considered parental assets on the FAFSA. When a school calculates the student's Expected Family Contribution (EFC), only a maximum of 5.64% of parental assets are counted. This is quite favorable compared to other student assets, which are counted at 20%. Higher EFC means less financial aid.

I personally believe the benefits of 529 plans outweigh any disadvantages. Interested in establishing a 529 plan? The website SavingforCollege.com (opens in new tab) offers additional resources.