The Rising Cost of Getting Ahead

It’s the first day of fall, and even though our family lives in California my mind still wanders to Burlington, Vermont at this time of year. For four incredible years I was a student at the University of Vermont studying finance. I learned a lot during those years, but it wasn’t until I had kids of my own that I really put in the time to wrap my head around paying for that magical college experience.  

My first discovery was that those millennials weren’t kidding! The cost of college is out of control and predicted to get even more onerous.  Check out this graph to see what’s getting cheaper and more expensive in the US. I am happy to report that toys and clothing have been getting relatively cheaper, but I am astounded by how much college costs are rising!

What to do?

Our economy has been rapidly shifting towards “knowledge work” so even though it's expensive, I believe college is probably the most sensible path for my two boys. They could get a full ride based on academic or athletic ability, but they seem to take after their old man so we need a solid plan B. Financial aid is not available for every family and most financial aid consists of loans which increase the total cost. My wife and I may not cover the entire cost of college, but we want to do what we can to help our boys avoid a mountain of debt. So, if it’s not free and we don’t want to borrow excessively, we need to save up for their educations.

In my opinion, a 529 plan is currently the best option for saving for college. A state-run 529 account is like a Roth IRA, but it’s aimed at college rather than retirement savings. All fifty states and the District of Columbia sponsor at least one type of 529 plan. You invest post-tax dollars in a basket of mutual funds and the earnings grow tax-free until you make a withdrawal. If you use the money for certain education-related expenses, you will not be charged capital gains tax on the funds you remove. Qualified expenses include tuition, required fees, books, supplies, computer-related expenses, even room and board for someone who is at least a half-time student. Some states also offer tax deductions or credits to their residents for making contributions.

Setting up a 529 Account:

Setting up a 529 account is actually very easy. First you need to choose the plan that works best for your situation. Savingforcollege.com and other similar sites offer reviews, cost estimates, and investment options for the various plans. Some states offer tax incentives for saving, so be sure to check out your state’s plan even if it isn’t on one of the “5 best” lists you’ll find online. Once you select a plan, visit their website and follow the prompts for establishing and funding your plan. You will need information for the account owner (usually a parent), the beneficiary (usually their child) and a successor account owner who would manage the account if the owner is deceased. A 529 account is owned and controlled by its owner, so you decide what happens to the funds in that account.  

Once the account has been established, you can make lump-sum contributions (subject to gifting limits) and set up auto-deposits from your bank account. Perhaps the best feature of the 529 is that you can share a link with grandparents, aunt and uncles and other loved ones so they can contribute to the beneficiary’s education.  

Note: 529s usually work best when a parent is the owner and their child is the beneficiary. If someone other than a parent sets up the 529 for a child, the assets won't be captured on the FAFSA, but the money paid out that account for the child's education will count as untaxed income for the child, which will be captured on the next FAFSA and reduce their aid by 50 cents on the dollar. If a non-parent is insistent that they be the owner, consider tapping those funds in their junior year when all FAFSAs for undergrad have been submitted.

Estimating the cost of college:

Now that you have an account, how much should you save? We really like this calculator provided by Vanguard.

College Cost Calculator

It allows for multiple children and lets you select specific schools…I dare you to plug in your alma mater to get some serious sticker shock. If you can’t save as much as they recommend, just contribute as much as you can without breaking the bank. Both you and the kids will be happy you did.

Common 529 Concerns:

How will a 529 plan will impact my child’s eligibility for financial aid?

The value of a 529 plan owned by a dependent student or one of their parents (529 plans do not allow joint ownership) is considered a parental asset on the FAFSA. Around the first $20,000 will fall under the Asset Protection Allowance (the exact amount depends on the parents' age). Any parental assets beyond that amount will reduce a student's aid package by a maximum of 5.64% of the asset's value. So, if a parent's 529 account exceeds the Asset Protection Allowance by $10,000, her child's financial aid award could be reduced by $564. Of course, no one wants to lose $564, but the tax-free investment gains you've earned in your 529 account will likely outweigh this tiny loss.

What can I do with a 529 account if my child does not end up going to college?

Most people don't realize that 529 assets can be used at many eligible institutions of higher education. That includes not only four-year colleges and universities, but also qualifying two-year associate degree programs, trade schools and vocational schools—both at home and abroad. This means that if your child takes a route outside of college that requires training, there’s a good chance you can pay for that training with your 529 assets.

If your child is not going to need the money for school, you will really appreciate that you are the account owner and have the right to change the beneficiary. If the new beneficiary is a family member—a sibling, first cousin, grandparent, aunt, uncle or even yourself—the money can be used for qualified education expenses without incurring income taxes or penalties. You can even make your future grandkids the beneficiaries when they arrive, allowing the money to grow tax-free for even longer.

Are there penalties if I don’t use the money for college?

In short, usually. If assets in a 529 are used for something other than qualified education expenses, you'll have to pay both federal income taxes and a 10% penalty on the earnings (plus an additional 2.5% in CA).  The contribution portion will never be subject to tax or penalized since it was made with after-tax dollars. Here are some situations where the 10% penalty on the earnings is waived.  You would still owe income taxes on the earnings.

• A beneficiary dies or becomes disabled.

• A beneficiary receives a tax-free scholarship.

• A beneficiary receives educational assistance through a qualifying employer program.

• A beneficiary attends a U.S. Military Academy.

• The qualified education expenses were used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC).

 

Recap:

• 529 accounts grow free of federal and state income taxes.

• Qualified withdrawals are free of federal and all state taxes.

• Qualified expenses include tuition, required fees, books, supplies, computer-related expenses, even room and board for someone who is at least a half-time student.

• Most tech, college and graduate school expenses are qualified.

• Qualified withdrawals include up to $10K annually for tuition (only) for K – 12.

• Beneficiary never has any rights or access to account.

• Owner always has daily access, liquidity and control.

• Owner may select an different, related beneficiary (rules apply).

• The 10% penalty is on the earnings withdrawn, not the full withdrawal.

Bonus:

California is very close to passing “Assembly Bill 211” which would provide a state tax deduction for contributions to the CA Scholarshare 529 plan. The proposed deduction will be up to $5,000 for single taxpayers or $10,000 for filing as head of household, a surviving spouse or a married couple filing a joint return. To qualify for the deduction, a single taxpayer must make no more than $75,000/yr or $150,000 for head of household, a surviving spouse or a married couple filing a joint return.

I find the income limits to be low considering the cost of living in California, and it would be nice to get the deduction no matter which state or institution sponsored your plan, but it’s a major step up from the non-existent deduction CA residents currently get.  

This article is a great primer on 529s, but there is always more to learn. If you have any questions, please reach out to us and we will be happy to share what we have learned!

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Jason Draut, CFP®
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Chris Sheehy, CFP®
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