As college costs continue to rise, parents continue to search for ways to lower the pain in their wallets from getting a college degree.
What could be better than having the money saved to pay for college? How about having help from Uncle Sam? But with so many choices, how can you most effectively accomplish the twin goals of paying for college and saving your retirement nest egg? I discuss many in my College Planning Service. Here is a little primer on some popular options.
With a qualified tuition plan, like a 529 Plan, you have a tax-free incentive to save for college. For years the investment industry has promoted the benefits of saving for college using these qualified tuition savings plans. But are they really the best or most beneficial option for you and your student?
WHAT IS A QUALIFIED TUITION PLAN and CAN IT HELP YOU?
Created under the Small Business Job Protection Act of 1996, qualified tuition savings plans (QTP) include a number of options that provide tax incentive savings for college savings.
The most popular of these options is the 529 Plan (named after the section of the code where they appear). But there are two varieties of these plans and understanding the differences may help you avoid some costly mistakes.
Generally, a QTP is an investment vehicle that allows someone to set aside money that can be used towards the expenses incurred at an eligible school or college. It can be used to cover the tuition and fees of an undergraduate degree or vocational program.
There are two key options: a prepaid tuition plan or an investment plan.
Prepaid Tuition Program
With this option, you can set aside a predetermined amount that the program manager agrees to use to cover the expenses for a particular time period. These options are limited to certain schools. And the school contractually accepts the amount set aside to cover the expense with the funds set aside. If a participant chooses not to attend, then the market value may be withdrawn (subject to limitations) and used at another school. But the value of the account may not be enough to cover the actual expense.
College Savings Plan
This is the classic version of a QTP. Money is invested for a particular beneficiary but can be used at any eligible school or program. The biggest difference is that the investment burden falls on the shoulders of the participant.
Investing in a 529 means that your student-beneficiary can withdraw the funds tax-free when it comes time to pay college costs. In some cases states offer a tax deduction for setting money aside (but not in Massachusetts).
Problems to Consider
A common complaint: It limits withdrawals to cover only eligible expenses. The money invested into the account is restricted to “qualified” expenses specific to your education. While this list is broad, certain school-related expenses may not be eligible.
If money from a 529 account is used on something not qualified, the investor is subject to income tax and a ten percent early distribution fee.
- Limitation on investment choices: You are limited to the plan menu offered by the state sponsor.
- Limitation on investment changes or rebalancing: You can only switch investments once per year. Or you can enroll in an auto-rebalancing feature (quarterly, semi-annually or annually) but there may be a cost.
- Fees and expenses may be high: In addition to the underlying mutual fund expenses (about 1% – 1.5% for actively managed funds), there is an advisor and state management fee. These can run about 1% to 1.5%. (A cheaper alternative involves low-cost Exchange Traded Funds). And in some cases, you may be paying a commission for the purchase of shares.
- Financial aid eligibility may be impacted: Assets held in such plans are assessed by financial aid. If you have a large enough balance, you may reduce your odds for receiving financial aid. The titling of the account can be critical to helping avoid this potential problem.
- Improper tax planning: If you’re in a low enough tax bracket (marginal rates under 15%), you may not benefit as much compared to the costs of the plan. These plans are better suited for those in higher tax brackets. And for estate planning purposes, they are ideal for grandparents looking to move large amounts of money out of their estate for the benefit of the living.
Need Help Understanding Your Options?
COLLEGE HELPLINE: 978-388-0020