Why Should You Invest in a Qualified Tuition Program?
March 24, 2019 | Jill Schwitzgebel, College Initiative and Stacy Miller, CFP®, Bright Investments
If you're the parent of a potentially college-bound child, chances are that you have spent more than a few minutes thinking about the best way to finance that dream. While I have written previously about how to understand how much college really costs, I have never written specifically about the best way to save for college.
But, since it's such an important topic for families, I turned to Financial Planner, Stacy Miller, CFP®, Vice President with Bright Investments, for advice. Below, Ms. Miller explains what you should know about 529 qualified tuition programs, as well as why you (or as she says, better yet, a grandparent!) should be investing in one for your child.
This is an update of the article I wrote for College Initiative in March 2019.
Let’s begin by talking about what a 529 savings plan IS, with recent updates following the SECURE Act (Setting Every Community Up for Retirement Enhancement), which was signed on December 20, 2019. It is defined by IRS publication 970 as a qualified tuition program (QTP). A QTP can help you to pay for qualified education. We’re deliberately not calling it a college savings plan because you can use it to fund so much more than college now.
QUALIFIED EDUCATION EXPENSES: tuition, room & board, books, fees, computers, and supplies for 2 or 4-year public or private colleges, trade schools, vocational schools, graduate schools, professional schools, K-12 schools (up to $10,000/year), and apprenticeships, AND student loan principal and interest payments ($10,000 lifetime limit).
The benefit of investing in a 529 savings plan is earnings are tax-deferred, but earnings will be TAX-FREE if used for qualified educational expenses!
For example, if you contribute $10,000 when the beneficiary is born and your investment yields 5% each year compounded, you’ll have $24,066 to spend on higher education. In another investment vehicle, you could owe taxes on the $14,066 in earnings. If you use the fund for qualified education expenses, you will owe nothing in taxes.
Here’s an even better example. If you (or maybe a grandparent) are able to contribute $75,000 (5-years forward funded at the 2019 gift tax annual exclusion rate of $15,000 per year) and your spouse also contributes $75,000, for a total of $150,000, with a 5% average annual return, compounded, over 18 years, you would have $360,993 tax-free to pay for higher education. That’s exciting!
But, what if you planned for your beneficiary to use these funds for education, and they don’t want to do that, or they’re not able to do that? Here are two more benefits of this plan:
- You can roll over these funds to benefit another family member, even yourself.
- You can roll over these funds (within annual limits) to an ABLE account for the same beneficiary who became disabled before age 26.
- You can pay up to $10,000 in student loans for each sibling of the beneficiary.
There are, as you might imagine, a few cons to this plan:
- Like any investment, the returns are not guaranteed and there are fees and expenses associated with these accounts.
- There are limited investment options available, but there are many good ones.
- If you withdraw these funds for anything other than qualified education expenses, you’ll pay ordinary income tax on the earnings PLUS a 10% penalty. If the beneficiary gets a full scholarship, the 10% penalty is waived.
- Contributions are not tax-deductible in the year they are made.
- The value of the 529 savings plan is counted as an asset that is considered in the expected family contribution calculation in the Free Application for Federal Student Aid (FAFSA) EXCEPT if a grandparent is the owner. (See what we mean about the benefits of having generous grandparents?)
- Distributions are considered student income in the year they are made, and this can also affect the expected family contribution calculation on the FAFSA. For example, if your student completes his FAFSA in October of his junior year of college, then pulls money out of the 529 account, it won’t affect future financial aid, and he’ll be able to pay for almost two years without worrying about that consequence.
- If you pay student loan interest with 529 Plan funds, that interest is no longer tax deductible.
The inflation rate for college tuition over the next 15-20 years is estimated to be 5% per year. I highly recommend that you invest early in a 529 savings plan in order to utilize the tax-free compounded returns. There are other savings plans options, but none with the tax benefits and flexibility of the 529 savings plan.
Each individual’s situation may vary, so be sure to contact your own financial advisor for specific advice.