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How Educational 529 Investment Plans Work

Aug 14, 2012

This week we’re going to be talking about an important area of college financial planning that for many parents is often very confusing: that is, 529 plans. For many of the parents we work with who have students in their sophomore, junior or senior year in high school understanding what 529 plans are and whether they can be useful is an important question that needs to be answered. So in order to best answer this question we’ll first start talking about the purpose behind 529 plans.

The purpose behind 529

529 plans are a type of savings vehicle designed specifically to help families financially prepare to send their children to college by making consistent contributions to the fund before the student attends college. With total 4 year college expenses for 2010 totally anywhere from $30,000 up to $300,000 and rising 6% per year the United States government has recognized that for many parents raising the necessary cash to pay for college needs to be a long term strategy. With that in mind, the IRS in 1996 created section 529 which allowed a special tax exempt investment vehicle to be created to help make saving for college easier for families across America.

529 plans are similar to other mutual funds or investment accounts in that when you make contributions to the plan the 529 fund manager will invest those funds into a diverse array of stocks, bonds etc that correspond to the investment goals outlined by that manager. 529 plans differ however in that the manager who runs these funds have to adhere to the specific guidelines and regulations inherent to the plan in order to better ensure that the funds are conservatively invested in ways to make sure the money is available for families when the student is ready to attend college.

A 529 Plan is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996.

529 Plans can be used to meet costs of qualified colleges nationwide. In most plans, your choice of school is not affected by the state your 529 savings plan is from. You can be a CA resident, invest in a VT plan and send your student to college in NC.

Enrolling in a 529 plan

There are two ways to invest in a 529 plan.
  1. Directly with the 529 Plan manager. 
  2. Through a financial advisor. 
Here are the top advantages and disadvantages of 529 plans as indicated by the College Planning Saturday staff:

Top Advantages
  • All the account’s earnings are exempt from federal tax when they are withdrawn if they are used for qualified education expenses. This means that, unlike the taxes you have to pay on earnings from regular stock investments, you won’t pay any tax on the 529 account earnings unless you end up using the money for something other than higher education. Earnings are currently tax-deferred in most states as well.
  • A break on the earnings tax isn’t the only tax advantage, either. Although your contributions aren’t pre-tax (you pay state and federal tax on the money you put into the account), there are some states that let you deduct a portion of your contributions from your state taxes.
  • Unlike custodial accounts or Education Savings Accounts (ESAs, IRAs) the beneficiary does not gain control of the money at a specific age (usually 18 or 21 for those types of accounts). The account owner always has control of the money. This helps lessen that parental anxiety that their children may use the money for purposes outside college expenses.
  • There are no restrictions on who can open a 529 account for whom. You can open an account for your child, a friend’s child, a relative or even yourself.
  • Anyone can contribute to the account

Top Disadvantages
  • This may not be suitable strategy for someone who has child about to go to college in less than 2-4 years. It would be better to invest in a traditional mutual fund as the fund expenses would be much lower than in the 529 Plans.
  • Investing in a 529 plan may reduce a student’s eligibility to participate in need-based financial aid.
  • A withdrawal for non-education purpose may be subject to income tax on the gains only and an additional 10% federal tax penalty on earnings.
  • Of the 45 states that have established plans, 27 of them charge expenses of more than 1% per year and 10 of those states take additional sales loads. These fees are considerably higher than those normally charged in a regular mutual fund or investment account

How 529 Plans Work in Action

Here is a simplified example of how 529 plans works:

You file the FAFSA aid application when your child is a senior in high school. Let’s say you have a 529 savings account (you are the owner, not your child) with $20,000 in it of which $10,000 represents your original contribution and $10,000 is earnings.

Year 1:

Your eligibility for federal financial aid this year will decrease by no more than 5.64% of the account value, or $1,128 ($20,000 x 5.64%). Assume there is no further appreciation in the account and you withdraw $5,000 in the fall to pay for the first semester college bills.

Year 2:

You have $15,000 left in the account when you apply for aid for sophomore year, and you will again be assessed up to 5.64% of the account value or $846 ($15,000 x 5.64%). The $5,000 withdrawal brought $2,500 of excluded earnings with it, but as indicated above, none of the withdrawal is counted as financial aid income.

The federal aid formula is more complicated than what is described here, but this gives you a general idea of how to calculate the financial impact of a 529 savings account.

Sound complicated? It is. And we are only talking about the federal financial aid rules her-each school usually sets its own rules when handing out its own need-based scholarships, and many schools are starting to adjust awards when they discover 529 accounts in the family. Also consider that the federal financial aid rules are subject to frequent change. Finally, remember that most financial aid comes in the form of loans, not grants, and so you end up paying it back anyway if you don’t understand how the school incorporates 529 plans into their financial aid award decisions.

The Bottom Line

The bottom line about 529 plans is that fundamentally they operate as a savings account. This means that if you choose to use one you need to make sure you start early so that the accumulated earnings will have the opportunity to grow enough to benefit the family. It’s also important to understand comprehensively how 529 plans are handled by the college’s financial aid office so that your hard work and savings aren’t penalized by the institution reducing your family’s financial aid award because you have one. Last, like all savings accounts with assets invested in the market it’s incredibly important to understand what type of account you have so that you properly understand the level of risks and rewards within the plan so you have a good forecast of what your projected out-of-pocket costs will be when the tuition bill arrives.

For many families, finding the extra income necessary to consistency make contributions to a 529 plan is challenging in light of the many new and constantly changing bills and expenses faced on a daily basis and as a result understanding what strategies and techniques are available to immediately increase financial aid awards and minimize out-of-pocket costs should be of vital concern. If you’re looking for tools and strategies available to immediately increase the quality of your student’s financial aid package then I invite you to attend one of our free workshops hosted by me for advice and consultation by clicking on the following link to discover our next available free workshop.

To discover the business-side behind the admissions and financial aid process the “stuff-behind-the-stuff” sign up to receive (1) a free chapter of Phillip Lew’s College Planning book, (2) a report on which colleges give grants for high income families and (3) a database on where to find the highest quality private scholarships. To instantly receive these free gifts go too www.totalcollegesolutions.com and watch our 5 minute introductory free video.

About the Author: PHILLIP LEW

*America's Leading Authority in College Planning

Articles Source: How Educational 529 Investment Plans Work

Got further questions? Catch me on twitter and DM me @529SavingsPlans or e-mail me at 529CollegePlans at Gmail.comWant to be heard? Leave a reader comment below.

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