Numerous studies show that individuals earn income that is directly correlated to their level of education. The higher one’s level of education, the greater one’s lifetime earnings. Think of a labor in an onion field with a grade school education versus a software engineer with several decades of education. If you are considering how you will afford your child’s college costs, you may be wondering if a 529 college savings plan is the right choice.
We have seen through our experience with the novel coronavirus that education can be related to personal safety at the work place. Individuals with a high school education or less often work in jobs that require physical activity and many of these jobs have been on the front line in the pandemic. Think about that field worker living in cramped shared-housing. Highly educated individuals work with information and perform advanced skills and many of them have been able to practice physical distancing throughout the pandemic. That software engineer was allowed to work from home.
Education provides a ticket to a better life. However, the cost of an education is often a major obstacle. Student debt has become great burden borne by many young adults after they graduate and enter the workforce. This debt can prevent young people from moving out on their own, getting married, and starting a family.
The key to getting an education, other than studying hard, is to save for it. The best way to save is the 529 college savings plan.
What Is a 529 College Savings Plan?
The 529 plan originates from a section of the Internal Revenue Code which was added in 1996. It authorized the use of these accounts to pay for qualified tuition without the payment of taxes on the gains inside these accounts.
Types of Plans
There are two basic versions of a 529 plan: a prepaid tuition plan and the college saving plan. We will devote our attention to the latter, as it is the far more common of the two.
Federal Tax Benefits
The major attraction of the 529 college savings plan is the tax benefit. The growth of these accounts is tax-free. Here’s an example:
Assume you invest $5,000 a year over 20 years to educate a child. So, your total investment is $100,000. You would pay no tax on any of the income during this accumulation period. Now, let’s assume that at the time you wish to begin taking money out of the account, it has a value of $150,000. So, the gain is $50,000. All of the distributions from the account are tax-free, as long as they are used to pay for “qualified higher education expenses.”
State Tax Benefits
Many, but not all, states offer a tax benefit for state residents contributing to the state’s 529 plan. In Oregon, residents may receive a state income tax credit up to $300 for joint filers up to $150 for single filers on contributions made to their Oregon Colleges Saving Plan account.
California and Washington State, unfortunately, do not offer a deduction for contributions to its (or any) 529 plan.
The definition of qualified higher education expenses has been expanded several times over the years to include expenses that range from laptop computers to K-12 tuition. The defines these expenses as “Qualified expenses are amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution.
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Contributions into a 529 account are treated as gifts for tax purposes. A person may gift up to $15,00 into a 529 account without tax consequence. It is possible to super charge a 529 account by bunching gifts into it. Specifically, you may put 5 years of gifts or $75,000 (5 X $15,000) into a 529 account in one year. However, it will not be possible to make tax free gifts in the subsequent four years.
529 plans offer a variety of investment options. Age-based investment options are packaged portfolios that have risk characteristics that are directly related to the age of the student/beneficiary. As the beneficiary gets older and closer to college, the portfolio will automatically rebalance into an ever-more conservative asset allocation.
A static investment option is characterized by an asset allocation that does not change over time. These options are offered based on the degree to which they are risky (i.e. conservative to aggressive), their exposure to markets (e.g. US stocks, international stocks, etc.) or based on some kind of environmental, social, or corporate governance screen.
Investors may also have access to a broad menu of funds similar to that found in a robust 401(k) or 403(b) retirement plan. The account owner can build a portfolio using these funds in an a la carte manner.
There are some reasons why you may not wish to use a 529 college savings plan. There are limits on how much you can invest in them. If you take out the money for expenses that do not qualify, you will pay taxes on the (earnings portion of the) distribution and a 10% penalty. Ownership by anyone other than the student or parent can make qualifying for financial aid problematic. Also, the expenses of a 529 college savings plan can be burdensome, particularly if it is an “advisor sold” plan.
College is expensive. The University of Oregon costs approximately $30,000 for residents and $57,000 for nonresidents. UC Berkeley costs approximately $40,000 for residents and $70,000 for nonresidents. The University of Washington costs $30,000 for residents and $57,000 for nonresidents. Private colleges are generally higher.
So, four years of college can cost $120,000-$300,000. That’s a lot of money. How do most people do it? They start saving early and they save systematically over many years. If you do that, you can get there.
Let’s assume you want to have $150,000 saved for a child’s college education. If we assume you save over 20 years and earn 5% (on average), you need to $3,850 per year. That’s achievable for most middle-class Americans.
If you have additional questions about 529 college savings plan, there are lots of resources on the internet. You might also speak with a CERTIFIED FINANCIAL PLANNER™.