To encourage families to start saving early for college, all states now sponsor what are commonly called 529 plans. Named after the section of the federal tax code that allows them, they offer significant tax benefits.
There are two basic types of 529 plans: savings plans and prepaid tuition plans. The more popular is the savings plan.
With a 529 savings plan, parents open an account and choose an investment strategy. Earnings accumulate tax free and withdrawals can be made tax free, when it’s time to pay for a child’s college expenses including tuition, books, and room and board.
How it works
Money from a state-sponsored college savings plan can be used to pay for educational expenses at any accredited college or university.
Each savings program offers parents several different investment choices. Because many state programs are open to nonresidents, it makes sense for parents to shop around for a plan that best meets their financial and educational needs.
A popular type of college savings plan begins with some aggressive investments and grows more conservative as the potential college student grows up.
Many plans allow anyone — from any state — to contribute to a 529 plan. If you start a 529 account for your child in your home state, grandparents or even friends can contribute to it, even if they live across the country.
For example, if you start a 529 plan in Minnesota, relatives or friends who live in Oregon can still contribute. The caveat is that some states may charge residents a tax on earnings on out-of-state 529s.
So you’ve planned ahead for your child’s education. What happens if a potential college student decides not to go to college?
Some parents hang on to the 529 plan in case the child decides to attend university at a later date. Others transfer the account over to another family member.
Some parents decide to cash out the plan and pay a penalty. Most states collect a penalty of 10 percent of the earnings on any withdrawal that is used for non-educational purposes.
A federal penalty equal to 10 percent of earnings will be charged as well. No penalty will be assessed if a beneficiary should die or become disabled.
While the tax-free withdrawals clearly make 529 plans attractive financial options, they may not be right for every family. The reason? Participating in a 529 plan affects a family’s eligibility for financial aid.
Who can benefit from a 529 plan?
Some financial advisers urge lower-income families, who are likely to receive a large amount of financial aid, to pass on 529 plans. If you’re likely to qualify for financial aid, the existence of a 529 savings plan may reduce or eliminate the amount of aid you can receive. That’s because for financial-aid purposes, savings plans are considered an asset of the account owner.
If the parents hold the plan, the amount of financial aid the student may be eligible for will be reduced by up to 5.6 percent of the savings account. A family with $40,000 in a 529 savings plan, for example, would see their financial aid decrease by as much as $2,240.
College savings plans may make the most sense for upper-income families who won’t qualify for financial aid and for middle-income families who qualify for loans and little else.
529 plan Risks
While a state-sponsored plan has benefits, the costs may be higher than you think. Invest in a high-priced plan and you’ll lose a nice chunk of earnings to hefty management expenses and other fees.
Let’s say your family contributes $600 a year to a college savings plan with a $50 annual maintenance fee. And let’s suppose an 8 percent return. By year’s end the account balance would swell to $648. But that $50 maintenance fee would knock it back down to $598. So after a year of investing, you’ve got $2 less than when you started.
A key advantage of a 529 plan — tax-free earnings — matters little if fees eat up all or most of your earnings.
The good news is many college savings plans will waive annual maintenance fees to in-state residents, people who make automatic contributions and people with large account balances, often $25,000 or more.
The bad news? There are plenty of other fees to worry about. Several college savings plans charge you a one-time enrollment fees right from the get-go. These fees range from $10 to $90, and most are under $50.
Asset-based management fees
The most troublesome fees for families stretching to save for college are fees that are charged every year, such as an asset-based management fee. This fee represents the operating expenses of the college savings plan and is charged as a percentage of the plan’s assets each year.
A 1 percent, asset-based management fee means that a fee equal to 1 percent of the plan’s assets gets deducted each year. A 5 percent asset-based management fee means a fee equal to 5 percent of the plan’s assets gets deducted each year.
The higher the asset-based management fee, the more earnings get swiped out of your account every year.
Be sure to look for management fees and expenses associated with the individual mutual funds you’ve chosen in your college savings plan. This kind of fee is called an underlying fund expense and is charged as a percentage of the assets of a mutual fund.
Some states include underlying fund expenses in a plan’s asset-based management fee. Other states charge underlying fund fees separately. Be sure to check.
Expenses vary widely between 529 plans. Some plans charge asset-based management fees below 1 percent. Other plans charge annual management fees exceeding 8 or 10 percent. Choosing a low-cost 529 plan could save you hundreds of dollars in fees every year.
Let’s say you’ve got $10,000 invested in a college savings plan. Choose a 529 plan with an annual operating expense of 1 percent and you’d pay a fee of $100 after a year. Choose a plan with a 10 percent operating expense and you’d pay a $1,000 fee after just one year.
The Fee Effect
|Plan A||Plan B|
|Annual Rate of Return||10%||10%|
|Term of Investment||18 years||18 years|
Suppose you invest $10,000 in a college savings plan with an annual operating expense of 10.97 percent. Let’s say you get a return of 10 percent before expenses. After 18 years, you’d have just $6,866 saved for college, more than $3,000 less than when you started.
Now let’s say you invest $10,000 in a college savings plan with an annual operating expense of just 0.85 percent with that same 10 percent return. After 18 years, you’d have $47,680 to pay for college expenses, an increase of $37,680.
Finding a fruitful 529 plan
A state-by-state listing of programs can be found at Bankrate’s interactive locator. Savingforcollege.com, also provides a 529 Evaluator that lets you compare 529 plans by cost and several other categories.
Expenses: Keep in mind that annual expenses also could vary widely within a single college savings plan. It all depends on the investments you choose.
Loads: You’ll see the biggest swing of investment costs within a single plan when you select a college savings plan that charges initial or deferred sales loads.
With an initial sales load you pay a fee as soon as you purchase an investment option.
Let’s say you invest $10,000 in a mutual fund with an initial sales load of 5 percent. The fee is $500, so only $9,500 actually makes it into the mutual fund.
With a deferred sales load, you’re charged a fee after you withdraw money from an investment. This fee gets lower and lower the longer you hold on to an investment.
Many financial advisers encourage parents to avoid 529 plans that charge load fees. With such a short time horizon to save for college, 18 years and often much less, it’s important to keep your investment expenses as low as possible.
Low-cost plans: Looking for a low-cost 529 plan? A state-sponsored 529 plan managed by TIAA-CREF or Vanguard are good places to start. These plans offer a diverse set of investment options at a low price.
When it comes to studying the costs of a 529 plan, take your time and make sure you understand all the details.
The key thing you’re looking for is a low-cost 529 plan with a diverse set of investment options. Try to stay with annual expenses of 1 percent or less. Any plan with annual expenses that exceed 1.3 percent should be considered on the pricey side.
Families looking to steer clear of high fees will want to pass on broker-sold 529 plans. A broker-sold 529 plan could be two or three times more expensive than a 529 plan offered directly from a state. In general, direct-sold plans have lower costs.
Staying in state
Before studying 529 plans from across the country, be sure to take a hard look at the college savings plans available in your state. The reason? Your state may offer some pretty substantial state tax incentives and other benefits for choosing one of its 529 plans.