It is sometimes hard for parents of newborns to imagine their babies as teenagers heading off to college. But to be best prepared, parents should plan for that day proactively, even before their baby arrives.
Rising costs mean many parents today place an ever-larger emphasis on saving for college. According to The College Board’s “BigFuture” calculator, the current average amount for tuition and fees for a public four-year college is $9,410 for in-state students and $23,890 for out-of-state students. For private, four-year colleges, the average is $32,410. “My College Guide” reports that students pay an average of $8,887 per year for room and board at public colleges and $10,089 at private schools. This implies a total cost for a four-year degree of between $73,000 and $170,000, depending on the type of school a student attends. Parents who want to give their children a wide choice of schools while also avoiding the pitfalls of student loan debt can benefit from the head start and tax benefits a 529 account offers.
Saving for college is a long process that requires an organized and disciplined approach. A 529 account provides the opportunity to begin saving for college as soon as you are ready to start contributing. The earlier you do so, the more you will benefit from tax-free compounding. You can start a 529 plan at any time in your own name, and as soon as your baby has a Social Security number, you can name him or her the account’s beneficiary.
There are two different types of 529 accounts: a college savings plan and a prepaid tuition plan. The latter allows you to prepay for college credits at current prices. To ensure the full amount of tuition will be covered, the beneficiary must attend an in-state public college. Alternatively, the plan may offer to pay out an amount equal to the average of your state’s public colleges’ tuition to a private university of your choice. Any costs above that amount would need to be paid out of pocket or through a 529 college savings plan.
Generally, at Palisades Hudson we recommend avoiding prepaid plans altogether. They force investors to rely on the state’s future ability and willingness to meet its financial obligation, as opposed to giving the investor control. Prepaid plans also may build in time parameters, such as using the assets within 30 years of opening the account; 529 savings plans typically are not subject to such limits.
A 529 college savings plan is designed to encourage account holders to save for the beneficiary’s future college costs. The beneficiary has no legal right to the funds in the account, which provides assurance that the funds will be used only for the purpose you intend. Account funds can be withdrawn tax-free as long as they are used for qualifying education expenses, including tuition, books, room and board. Funds in 529 savings plans can be used at any private or public institution. Nonqualified withdrawals are subject to federal and state income taxes and a 10 percent penalty.
Thanks to recent tax legislation, you may also be able to use your 529 account to pay public, private or religious K-12 tuition expenses, up to $10,000 per year, per beneficiary. However, keep in mind that since 529 plans are administered by states, they have the final say on how their particular plans work. Some states have not yet updated their plans’ language to align with federal tax law. Since this change would be detrimental to the tax revenue of some states, they may not rush to implement it.
One benefit of 529 savings plans is the ability to shop around. Investors are not required to participate in their home state’s plan, and so can benefit from comparing their state’s plan with others. When choosing a Section 529 plan, focus on fees and investment options. A plan that delivers a diversified portfolio while minimizing expenses will permit greater growth.
Typically, management fees for 529 accounts range from 0 to 0.99 percent. New York state, for example, offers a plan with a 0.15 percent asset-based fee. Connecticut’s plan has a 0.12 percent fee, plus a 0.01 percent administrative fee. The plan’s administration fees are not the only costs to consider. You should also evaluate the underlying investments’ fees, which can climb as high as 1 percent. While many states do not charge an enrollment fee at all, most that do set it at $50 or less. Some also charge annual maintenance fees; though these are typically minimal, at around $10 to $25 per year, we still recommend trying to avoid them. If the account is set up for automatic contributions, many plans reduce or eliminate this fee, especially for residents. Plan administrators deduct account expenses directly from an account’s investments, so limiting fees is essential to promoting account growth.
The 529 plan that you choose should also provide diverse investment options through various asset classes. We typically recommend our clients open a 529 plan through my529, a Utah program, unless they will receive a tax benefit by opening a 529 plan in their home state. My529 offers quality investment options and flexibility with minimal fees. Many states do offer tax deductions for contributions to a 529 plan, however. If you live in New York and use the New York 529 plan, for example, you can deduct up to $10,000 annually. This sometimes, but not always, gives your home state’s plan an edge in financial comparisons.
Ensuring that your account is properly and diversely invested will provide your best strategy for long-term growth. Just as in all financial planning, there is no one-size-fits-all approach for selecting the mix of assets in a 529 account. The beneficiary’s age will affect the account’s investment strategy, since this effectively determines the investments’ time horizon. The younger your child, the more benefit you will likely see from a relatively aggressive asset allocation. We recommend starting your account with a 100 percent equity allocation and transitioning to more conservative investments as the time for college nears. The process of adjusting the account’s asset allocation as you approach a goal – in this case, your child’s college enrollment – is commonly known as an account’s “glide path.”
For many savers, we recommend maintaining a 100 percent equity allocation for younger beneficiaries, typically until they reach age 12. Around this time, you should start shifting 10 percent of the portfolio to fixed-income investments each year, to decrease the portfolio’s level of risk. This glide path will result in a 100 percent conservative allocation by the child’s last year of college in a four-year degree program, assuming he or she goes directly into a program after high school.
You may also choose a static portfolio, where the allocation is initially set to remain the same throughout the life of the account. The account owner can still make manual adjustments, if need be; like any portfolio, you should never simply set an asset allocation and then walk away entirely. The asset allocation of your 529 account should reflect your tolerance for risk.
If your 529 account balance exceeds the beneficiary’s undergraduate education costs, you have other ways to use the excess funds without triggering tax consequences. You can use the remaining assets to cover further education costs, such as graduate school tuition. You can roll over the funds into the college savings account of the beneficiary’s siblings, or your child could eventually name his or her own children as successor beneficiaries of the account. Even if the beneficiary decides not to go to college at all, you can change the beneficiary outright, as long as the new beneficiary is related to the previous beneficiary. This could even include transferring the account to the original beneficiary’s aunts, uncles, nieces, nephews or first cousins.
Once you select a 529 plan and begin to make contributions, beware of gift tax consequences. Contributions to 529 accounts qualify for the annual federal gift tax exclusion, which means you can give up to that amount ($15,000 in 2018) per beneficiary without any tax consequences. You can also make a lump sum gift – up to $75,000, or $150,000 for married couples, in 2018 – and elect to split it evenly across five years on a pro-rated basis in order to avoid owing tax on the gift.
If you do not plan to start with a large initial contribution, rest easy; initial minimum contributions to 529 accounts are generally low. While specifics vary by state, in many cases the minimum can be as low as $25. For most states, you can continue to contribute to the account until the balance for a particular beneficiary reaches a preset amount, ranging from $235,000 to $520,000 depending on the state and plan type. Bear in mind, too, that anyone can contribute to the account on a beneficiary’s behalf. Consider asking for contributions as a baby shower gift or in lieu of birthday presents for young children to help kick off your savings early.
Parents of newborns face dozens of decisions every day. What type of crib to use? What is the best way to swaddle? While answering these questions will help your baby sleep well, answering the question of how you will save for your child’s college education will help you sleep well too.