By: Josh Slocum, McClellan Wealth Management
When my brother had his first baby, like many people, he knew he wanted to set up a college savings account for her. He wanted to make sure he was putting enough money back to help her go to college and further her education. But also, like most people, he wasn’t sure of the best way to go about saving, nor how much he needed to be putting back each month.
I’ve had many clients in this same boat, and when it comes to saving for college, I almost always recommend a 529 Plan to my clients in Alabama, largely because of the tax advantages.
First off, what exactly is a 529 Plan?
A 529 plan, legally known as a “qualified tuition plan”, is sponsored by states, state agencies, and authorized by Section 529 of the Internal Revenue Code. It is a tax-advantage savings plan that encourages saving for education.
The biggest reason Alabama residents might want to consider using an Alabama 529 Plan is because it’s actually a very good plan, and you get a small state tax deduction from your contributions to it. The fees on them are very low, and for most families, putting some money into a 529 Plan makes a lot of sense. Now, there are penalties for non-qualified withdrawals and the investment options are somewhat limited so it’s important to also understand the disadvantages involved in 529 plans.
(Not to mention, there aren’t many ways to put money in your kid’s name without them knowing about it – besides trust and trusts are expensive-, and a 529 Plan is a great way to save for them and know the money will be used wisely.)
Prepaid Tuition Plans vs Education Savings Plans
Each state has at least one type of 529 plan, either prepaid tuition plans, education savings plans, or both. But, what is the difference between each plan?
Prepaid Tuition Plans
Prepaid tuition plans allow an account holder to purchase credits at their current prices for colleges or universities. The colleges or universities that sponsor this plan are usually in-state or public institutions. However, prepaid tuition plans don’t include the option to prepay for elementary and secondary schools tuition or boarding costs at colleges.
The state government sponsors the prepaid tuition plans. It’s important to remember that these payments aren’t guaranteed and there is a possibility that all of your money in the plan may be lost if there is a financial shortfall.
Educational Savings Plans
Educational savings plans allow a saver to open an investment account in order to save for qualified higher education expenses. The difference is that living costs are included, savings can be used for particular non-U.S. colleges and universities, and up to $10,000 per year can go toward paying the tuition of any public, private or religious elementary or secondary school of your choosing.
Savers can choose among a range of investment options such as various mutual fund and exchange-traded fund portfolios, static fund and age-based portfolios, or a principal-protected bank product. Age-based portfolios can shift toward conservative investments once the future attendee grows closer to the college age.
Although sponsored by state governments, only a few educational savings plans have residency requirements. Investments are not guaranteed and neither are investments in mutual funds by the federal government. Just like prepaid tuition plans, there is a possibility that you could lose some or all money invested.
How Much Should I Put in a 529 Plan?
“How much do I need to put in it?” is typically the next big question, and how much you’ll want to put in depends on the education you’re planning for – in-state, out of state, or Ivy League.
But let’s just think for a minute what makes sense.
If you want to put the minimum back, let’s plan for an in-state school like a state university. Now, if you want to plan for Harvard, just keep in mind that they can still use what’s in this plan, but more than likely, they’ll get some sort of scholarship if they do end up attending an Ivy League school.
So my advice to clients is – let’s plan for something in the middle of the road.
What Happens if the Beneficiary Does Not Use the Saved Money?
You, the parent, opened the account so you’re the owner. The child you’re saving money for is the beneficiary and not all beneficiaries end up needing all the money saved from a 529 plan.
You could have a child with stellar grades or a bright future in athletics who received scholarships. If that is the case, you could either reassign the plan to another beneficiary or get a 10% penalty to take the money out and do with it what you wish.
How Are Federal and State Income Taxes Affected By the 529 Plan?
The 529 plan has the ability to offer savers special tax benefits. In most states, you can deduct contributions from state taxes or match grants. By investing in your state’s 529 plan, you could be eligible for these benefits.
As far as withdrawals go, if the 529 account withdrawals are used toward paying education expenses, your account is not subject to federal or state income taxes. All other withdrawals will come with a 10% federal tax penalty. The tax-free earnings that grow within your account and the longer you invest your money, the greater your tax benefits.
Is a 529 Plan right for everyone? Maybe not. But if you’re hoping to help your child pay for college or further their education after high school, it definitely has some perks that are worth considering.
To learn more and discuss the best option for you, contact us online now or give Josh a call at (205) 208-9868
This material is provided as a courtesy and for educational purposes only and is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any security. Investing involves risk including loss of principal. Before investing or using any strategy, individuals should consult with their tax, legal, or financial advisor. The opinions expressed here are those of the author and not Advisor Services Network, LLC.