Hands down, a college degree is the single best investment a parent can make in their child’s future. But it’s also expensive. The tension between the need for a college degree and its cost is at the core of the anxiety parents experience over the college search process. Even when parents educate themselves to find colleges that offer generous financial aid packages, the financial burden can be more than families can afford from income alone.
So, what should parents do?
The most effective way for parents to prepare for anticipated higher education costs is to save. Period.
Here’s why — every dollar of parent savings will be “penalized” in the needs analysis by only five cents. That means that saving $10,000 will raise your expected family contribution (also known as EFC) by about $500, leaving you with $9,500 towards education costs. It’s a no-brainer.
In 1996, Section 529 was added to the Internal Revenue Code as an incentive to help parents save for college. Since then, 529 plans have become even more advantageous for families, and today, there are 15.7 million 529 savings accounts nationally. Over the years, their numbers and size have grown. In 2009, the average account size of a 529 savings plan was $13,188 and in 2021 it was $30,652.
Here are some of the main features of a 529 plan:
- Forty-nine states, the District of Columbia, and a non-profit consortium of private colleges offer plans that anyone, in any state, can use. Here’s where parents can find the 529 plans in their state.
- Earnings are tax-free if distributions are used for qualified education expenses (see the list below).
- Up to $10,000 can be used to pay the beneficiary’s tuition expenses at elementary or secondary public, private, or parochial schools.
- Up to $10,000 can be used to pay down the beneficiary’s student loans. An additional $10,000 can be used to repay student loans for each of the beneficiary’s siblings.
- 529’s are considered a parent asset on the FAFSA and CSS Profile — the two financial aid forms used by most colleges — even though the student is the beneficiary. This is an important advantage because parent assets are assessed at a much lower rate than are student assets in the needs methodologies.
The best way to save is to use time to your advantage. Better to make small but regular deposits to a 529 plan over long periods of time, rather than large deposits over a short period of time. This allows compounding interest to work in your favor. With a 529 plan, you can schedule regular direct deposits from a checking or investment account and painlessly watch your balance grow. As of December 2021, 38% of 529 savings accounts receive automatic contributions.
A big advantage of 529 plans is their flexibility. While it is generally sound financial practice to pay higher-education expenses from existing savings before beginning to borrow, parents may find themselves with leftover money in their child’s 529 account. Not a problem.
One option is to roll over the balance to a younger child’s 529 account. Another option is to change the account’s beneficiary to another family member, including a niece or nephew. A third option is to pay graduate school expenses from the 529 balance. A 529 account can even be used in future years for a grandchild. There are no fees associated with these changes, no penalties, nor are they taxable events.
Any amount can be withdrawn from the 529 account and used for any purpose, but at a potential cost. The earnings portion of a non-qualified 529 plan distribution will be subject to federal income tax and a 10% penalty solely on the investment earnings. So, it’s important to understand what a qualified expense is, and what isn’t:
- Tuition and fees—no limit for college, up to $10,000 per year K-12
- Books and supplies for education only
- Computers and internet access for education only
- Room and board for education only
- Special needs equipment for education only
- Student loans—lifetime limit of $10,000 per person
- Transportation and travel costs
- Health insurance
- College application fees
- Standardized testing fees
- Extracurricular activity fees
There are a few exceptions to the 10% penalty rule. These include when the beneficiary becomes incapacitated, attends a U.S. Military Academy, or receives a scholarship. In the case of a scholarship, non-qualified withdrawals up to the full amount of the scholarship will be exempt from the penalty, but not exempt from income tax on the earnings.
When it’s time to pay the education bills, 529 accounts are no different from any other savings account. Some even offer direct bill pay, allowing you to make payments directly to the institution. If not, you can simply transfer the needed funds into your checking account before making your payment.
Opening an account is simple, but it’s important that you shop for the plan that suits you best. Most have a very low initial contribution requirement — $25 is common — and an equally low minimum contribution level after that. Some states offer tax incentives for in-state residents, but other states may have a better historical return on investment, some states may offer no minimum initial contribution and other convenient features, while others may offer plans with a variety of investment approaches and levels of risk. With their enormous flexibility and ease of use, 529 savings plans are often a great way for parents to save for their children’s higher education costs.