Tuesday, October 26, 2010

Q&A Series – College Savings Plans

This week's question comes from Lynn, a young mom who is wondering about 529 plans for her son's college education.

Q: Everyone keeps telling me that my son will be heading off to college before I know it. Considering how fast his first two years have flown by, I can see that this will be true. You seem to recommend that parents open 529 plans to save for a child's college education. What makes them such a wise option compared to other college savings plans?

A: If there's one topic we're asked about most frequently, it's 529 plans. It's true that we encourage people to save for a child's college education by opening 529 accounts.  They are tremendously powerful savings tools, and if you are going to save and invest for your child's education, then a 529 plan is the best tax-advantaged way to do so.  

529 plans are college savings accounts wherein the investment income not only grows tax-free, but can also be withdrawn tax-free when used for qualified post-secondary educational expenses. These expenses include tuition, room and board, books and supplies, computers and Internet access, and the funds cannot be used for primary or secondary education. Couples can contribute up to $130,000 over five years ($65,000 for single parents) without generating gift taxes, and some states allow up to $300,000 in total. We believe that it is appropriate to have a minimum goal of $100,000 in a 529 plan to adequately provide for a child's college education. 

Another benefit of 529 plans is that the assets are considered to be the parents', not the child's. This is usually more advantageous than just keeping the money in your name. It also makes qualifying for financial aid a little easier than if the assets were held in a custodial account in the child's name since a child's assets are more heavily weighed when financial aid decisions are made.

Moreover, if a child doesn't use the assets from their 529 plan, those assets can simply be transferred to other children -- even if they are not related -- without incurring a penalty. And anyone -- whether it is the child's grandma, grandpa, aunt, uncle or a non-relative like a close friend or godparent -- can open a 529 for a child.

We believe that the best way to fund a 529 plan is by making electronic transfers directly from your checking account into the 529 plan (Rollins Financial can set up an electronic transfer for you at no cost).  If you opened a 529 plan when a child is born and electronically transferred just $100 into that child's 529 plan each month, then by the time the child turns 18, you will have accumulated $38,929 in the account (assuming a 6% interest rate).  At $200 per month, you will have accumulated $77,858, and at $300 per month, you will have accumulated $116,787 by age 18.  

Most people reading this post can likely afford some level of contribution for a child's education, but since relatives and non-relatives alike are also able to contribute to 529 plans, perhaps you will be lucky enough to receive some assistance in meeting this important financial goal.  Even if a child's grandparents are not alive at the time he or she enters college, there could be no greater tangible gift than assisting in financing a grandchild's education.

There are two types of 529 plans: "prepaid" or "savings" accounts. The advantage of prepaid plans is that you can pay a child's future tuition at today's rates; the disadvantage is that prepaying a plan will likely lock you into a state's or a specific college's higher education system.  Some states, but not all, do allow for refunds plus interest if the child changes his or her mind. Also, prepaid plans often don't cover secondary expenses like computers and Internet charges -- indisputably necessary tools for college classes -- and plan administrators invest all of the assets.

On the other hand, 529 savings plans are much more flexible. Simply put, you choose how to invest the assets from selected options. At the time the child enters college, you use the account to pay for his or her higher education. In all instances concerning 529s, the institution must be an accredited college or university. Also, the assets must be professionally managed, and depending on the plan, participants can choose from up to 30 mutual fund-type investments that can be changed once every 12 months.

Another type of college savings plan is the Coverdell Education Savings Account (ESA). In this type of account, the distributions are tax-free, you can invest the funds however you wish without using a money manager, and the funds can be used for primary, secondary and post-secondary education expenses. Unfortunately, contributions are limited to $2,000 per student per year; contributors earning more than $110,000 (single filers) or $220,000 (joint filers) do not qualify; the contributions are not tax deductible, and; the assets are considered in the financial aid calculation since they are considered to be an asset of the child. In our opinion, Coverdell ESAs are inferior to 529 savings plans.

Like any investment, 529 plans do have their risks, and it is possible to lose money by investing in one of these plans. However, we don't think the risks are great enough to avoid dipping your toes into these investment waters. Rather, we suggest that -- if your children are young and unless your child is due to begin college next fall -- you should dive in to this typically rewarding college investment plan option.

Obviously, all college savings plans are not created equal. It's imperative that you sit down with an investment advisor to evaluate your objectives, the types of investments offered, and any plan expenses before making your decision.

Lynn, we hope we have provided you with some useful information regarding 529 plans. If you would like for us to take an in-depth look at your particular situation, Rollins Financial's investment advisors are always available.

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joe Rollins

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