If you have been looking to save for college, you have probably heard of a 529.
Let’s define it. A 529 is a college savings plan that allows the owner to avoid Federal capital gains tax on the growth in savings when using the funds for college. Many plans also avoid state tax. These plans may be sold through independent advisors, financial firms, or state-sponsored plan sites. They typically come in the form of a savings vehicle (for example, a mutual fund) or a State pre-paid tuition program.
If you listen to the solicitors of these plans, they will tell you that these are the best college savings vehicles ever invented! It has become common for many professionals to say those three simple numbers when instructing you on how to pay for college. But, what do you need to know and when should you consider a 529?
Purpose of a 529
Let’s begin with the attorney’s compliance statement and reminder that you should consult with your trusted tax and financial advisors before making a decision on whether a 529 is appropriate for you. Here are some reasons why you should use a 529:
- It can accept a large amount of money. If you or someone that wants to help pay for college can invest enough to pay for your tuition, this can be a great vehicle.
- The owner of the account will avoid capital gains tax on the growth. This benefit will be enhanced in the future if we revert back to some of the high capital gains rates of the past.
- You have the comfort of knowing that college tuition and room and board costs are covered.
Drawbacks to 529s
Most of us don’t have a benevolent relative capable of giving us large sums of money. Since the greatest reason to open a 529 is to avoid the tax on the gain, the tax savings on small accounts rarely outweighs the cost for opening the account. Remember, there will always be some form of management fee, commission or both on any financial firm or investment. Those fees eat into the tax benefits.
A common error parents make is opening a 529 account when they only have a few years left to save prior to the start of college. Then they compound this error by investing too aggressively in hopes of making up for lost time. In recent years, we have seen this strategy create irreparable losses to their investments. The only positive has been the passive loss write off when they close the account (but this is a small positive only). Conversely, others are overly conservative, as they don’t want the account to suffer during turbulent markets. In those situations, with no market gain, there is no real tax savings or benefit of the 529 versus a straight mutual fund.
Another potential drawback of using a 529 is the fact that the tax avoidance benefits only apply if you use the account to pay for tuition and college expenses. It does not apply to the lifestyle related expenses of college.
What If You Get a Scholarship? The answer is that you better have another person (beneficiary) to share the 529 with, or you will be paying the taxes on the gain.And finally, the biggest drawback of a 529. It is included in the calculation of your EFC (Estimated Family Contribution) on FAFSA and the CSS profile. This can significantly reduce your ability to receive financial aide.
Who Should Use a 529?
So, now that we know some of the negatives, who should use a 529? This is great for families…
- with large incomes that would not be able to receive financial aid.
- with a long investment horizon and a sizeable amount to invest.
- who can keep the ownership of the account out of the immediate family, such as having the grandparents own the account.
If don’t you fall into these categories, you should strongly consider investment options that are not subject to FAFSA calculations.
Todd Rhine is the owner of Todd Rhine Planning (http://www.toddrhine.com). He sports an impressive roll of financial certifications (including CWC, CFP®, RFC®, CLU, ChFC, IAR). This post is part of a series of articles relating to financing college.