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by Deborah L. Meyer
August 16, 2017
by Deborah L. Meyer
August 16, 2017
Saving for college keeps getting more challenging. By 2024, the average sticker price for a year at public in-state college is expected to climb to $34,000, and for private school undergrads it could be $76,000, according to the College Board's 2016 study "Trends in College Pricing."
For people looking for ways to fund future college expenses, 529 savings plans and prepaid tuition plans could be the answer. They allow parents and grandparents to sock away money for college tax-free that grows in investment value as children grow up. To see if you understand how they work (and their key differences), try this quiz.
1. True or false: A 529 savings 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.
2. True or false: You must invest in the 529 savings plan of your home state.
FALSE. Many 529 plans allow out-of-state investors. But sometimes there are advantages to choosing your home state plan, such as matching grants and scholarships, protection from creditors and exemption from state financial aid calculations. Several states offer a state income tax deduction only if you invest in your home state plan. However, a few states (currently Arizona, Kansas, Missouri, Montana and Pennsylvania) provide tax parity, whereby you receive the state income tax deduction even if you contribute to an outside state's plan. So, if you live in a parity state -- or a state with less-than-stellar 529 offerings -- lower fees and superior historical investment performance may entice you to choose an out-of-state plan.
3. 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 The amount you initially contribute to a 529 plan can be withdrawn without penalty.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 a 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'd 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.
4. True or false: If you open a 529 for your child, when it's time for him to choose a college, it will need to be in the state in which the account was opened.
FALSE: Students can use 529 funds for any college or university eligible for Title IV federal student aid -- in any state and even at many institutions outside the U.S. In addition, students can attend certificate programs and vocational-technical school.
5. True or false: Parent- or student-owned 529 plans are treated as a parental asset in the financial aid calculation.
TRUE. 529 plan balances impact the federal student aid calculation for need-based aid. Assets in accounts owned by a dependent student or one of their parents are considered parental assets on the FAFSA (Free Application for Federal Student Aid). 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 with other student assets, which are counted at 20%. A higher EFC means less financial aid award.
6. True or false: A grandparent cannot own a 529 plan for his or her grandchild.
FALSE. Having a grandparent open and fund an account is good from an asset value perspective because assets of grandparents are not reportable on FAFSA. However, distributions from a grandparent-owned 529 plan may be subject to reporting on the FAFSA as student income. Furthermore, if the grandparent establishes a 529 plan for your child, the grandparent maintains legal control of the account. He or she could change the beneficiary or use money in the plan for personal expenses (subject to income tax and 10% penalty on earnings).
7. True or false: Private College 529 is the only prepaid 529 plan not run by a state.
TRUE. Historically, prepaid plans were state run and offered advanced tuition credits for in-state universities only. Now, nearly 300 private colleges and universities in the U.S. have joined together to offer tomorrow's tuition at today's prices.
8. True or false: Unlike 529 savings plans, a prepaid tuition 529 plan does not have market risk.
TRUE. One major benefit of a prepaid tuition plan over a 529 savings plan is the lack of market risk. The investment performance of a prepaid plan is measured by tuition inflation, NOT how the stock market performs. Basically, you buy tuition credits at a set price (typically a premium over the current cost of college) to be used for your child's education years down the road.
But keep in mind that while you're not facing market risk, you are facing the risk that the plan you've bought into could falter over the years. For example, College Illinois is on a path to insolvency, according to a recent story in Crain's Chicago Business. College Illinois is a state-sponsored plan, unlike Private College 529, which is not tied to a specific state.
9. True or false: Like a 529 plan, the Coverdell Education Savings Account (ESA) offers tax-advantaged savings for college.
TRUE. The Coverdell ESA grows tax-free, and funds can be used toward college costs. Certain K-12 expenses are also covered by the Coverdell ESA. Unlike the 529 plan, there are income restrictions on Coverdell contributions and special rules for beneficiary changes.
10. True or false: Gifting money to children is more favorable than 529 plans, from a financial aid and income tax perspective.
FALSE. Historically, gifts of money to children through Uniform Gift to Minors Act (UGMA) accounts were considered the preferred method for college financing. However, UGMA funds may be subject to the "kiddie tax" rules whereby the child is taxed at the parent's higher income tax rate; 529 plans are not subject to a kiddie tax. Colleges also count UGMA accounts as a student-owned (rather than a parent-owned) asset in the financial aid calculation -- resulting in a lower financial aid award.
Copyright 2017 The Kiplinger Washington Editors
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