Quinton Cannon | Financial Coach | The Financial Clinic
Robert F. Smith made national headlines in May when he announced that he would assume responsibility for the student loans of the entire graduating class of 2019 at Morehouse College. The graduating seniors were momentarily in shock before erupting with celebration. At the same time, college students – future, current, and prior – all around the nation surely felt envious as the story dominated their newsfeeds and social media accounts.
Just a few weeks before, Elizabeth Warren’s proposal to erase a significant portion of outstanding student loan debt sparked conversation about how different people’s financial situations would look if they were ridden of their student loans.
Notwithstanding the exciting (or envy-invoking) headlines about loan forgiveness, it’s critical for future students to save for school. As a financial coach, I often tell people that although we hope that relief of some form is on its way for students and borrowers, it is wise to plan for the future with the assumption that college is going to be expensive and that students will need to find a way to pay for it. So, when possible, it is a good idea for prospective students and their families to start saving now.
An excellent way for many families to save for college education is with 529 plans.
However, in my experience talking with customers, friends, and family about paying for college (yes, I am that weird person who talks to you about this kind of thing at parties), I have found that most people do not know about these plans or their benefits. When people do know about them, they often don’t fully understand how they work and/or have a few misconceptions.
So, let’s talk about what 529 plans are and analyze a few common myths surrounding them.
Why the Name?
Like 401(k) retirement accounts, 529 plans get their strange name from a section in the Internal Revenue Code 26, in which this particular education savings plan is defined. (The IRS has never had a reputation for using memorable or fun names).
What Are 529 Plans?
Also, like 401(k) accounts, 529 plans exist to incentivize Americans to save their future by providing tax benefits to those who use them. There are two types of 529 plans: education savings plans and prepaid tuition plans.
- An education savings plan allows participants to save in an account where their money can be invested and subsequently withdrawn without the account owner having to pay taxes on gains (as long as the funds withdrawn are used for qualifying education expenses).
- A prepaid tuition plan allows participants to purchase future credits at participating schools for what those credits would cost today.
Education savings plans are much more common – while almost all states offer an education savings plan, only 18 states offer prepaid tuition plans, and as of last year only 11 of those were accepting new enrollees. So, in this post, I will focus on education savings plans.
How Do 529 Plans Work?
529 education savings plans generally consist of an investment account in which enrollees can choose what type of portfolio they wish their money to be invested in. They can contribute to the plan as frequently (or infrequently) as they like.
When somebody enrolls in a 529 plan, they can either do so for themselves or for a beneficiary (i.e. somebody other than themselves that they are saving for). If they have multiple beneficiaries for whom they would like to save, they can enroll in a 529 plan for each one – it is not possible to have multiple beneficiaries on one plan. When the person for whom the plan is intended needs to use the money, it is pulled out of the 529 plan and used to cover “qualified expenses” (including, but by no means limited to, college tuition). A penalty is charged when 529 accounts are used for non-qualified expenses.
There is no uniform 529 plan across the country. Instead, states are responsible for offering and administering their own 529 plans. Each has its own incentives and benefits – some offer better deals to enrollees than others. Utah and New York, for example, have received a lot of national attention for their respective 529 programs.
While the default option would be to enroll in the 529 where you live, it’s actually possible (and sometimes a good idea) to enroll in a 529 plan outside of your home state.
How Do I Go About Choosing a 529 Plan?
The three main things to consider when looking at 529 plans are: additional tax benefits, fees associated with the plan, and investment options in the plan.
As mentioned above, the first plan to research is generally that of your home state. This is because many plans offer state income tax deductions to residents who participate in the plan – that is, contributing to a 529 plan can lower how much you owe in taxes at the end of the year. However, some states do not offer any tax incentive. Also, some states’ plans charge high fees and/or do not have many investment options. In either of these cases, it might make sense to research other states’ plans to find one that has low annual fees and good investment options.
Why Are 529 Plans Often a Good Idea?
Financial advisors often quote Einstein as having said, “Compound interest is the eighth wonder of the world.” While it’s doubtful that he actually said this, the point remains: money has an amazing way of growing over time and, whenever possible, it is nice to be the one earning this interest instead of paying it.
529 education savings plans provide a great opportunity to capitalize on compounding interest and put it toward something you care about. The earlier you begin contributing, the more powerful the effect of compound interest.
What if the Beneficiary on a 529 Plan Doesn’t Go to College?
If your beneficiary ends up choosing not to pursue a college degree, there are several alternatives.
529 plans can be used to pay for certain non-college expenses without incurring a penalty. For example, funds from a 529 plan can be put toward many vocational or trade schools.
The beneficiary on a 529 plan can be changed. Say, for example, that you had created a 529 for yourself but decided not to attend school; if you would, however, like your daughter or son to have the opportunity to do so, you can transfer the account to them.
You will not lose all of the money you saved if it is used for non-qualifying expenses. Although the money in a 529 plan does come with strings attached, it is yours, and you have the right to use it for non-qualified expenses. Bear in mind that if you do so, there will be a fee, and you will have to pay taxes on any of the accrued gains.
Do I Have to Use My 529 Education Savings Plan for a School in My Own State?
Many people think that funds deposited into a 529 educational savings plan must be used at a university in the state that the plan is associated with. Thankfully, this is not true. The entire balance of funds accrued in a 529 education savings plan can be used at colleges and other educational institutions throughout the country, regardless of which specific education savings plan the funds are stored in.
What Are Some Problems with 529 Plans?
Having highlighted some of the benefits of 529 plans, it’s important to recognize some of the drawbacks of these plans. These generally have to do with the way that the 529 system is set up – there is a lot of room for differences between the way states and different federal programs treat 529 accounts. Two important problems to consider are asset limits and quality of 529 plans.
Many families worry about the effect that opening a 529 account will have on their access to public assistance programs as well as financial aid for school. Sadly, this is definitely a cause for concern. Although many state and federal programs specifically exclude 529 accounts when considering whether an individual or family should qualify for a certain benefit, others, unfortunately, do take 529 accounts into consideration and this can impede some individuals from accessing certain types of assistance that they need. It is frustrating that we as a nation continue to disincentivize people from investing in themselves and their future, but for the time being some programs still fall into this archaic way of thinking.
529 accounts are also considered, to an extent, in determining financial aid awards to students when they fill out a Free Application for Federal Student Aid (FAFSA). The effect is generally relatively small. However, there are some potential snags to consider – for example, 529 accounts owned by students’ grandparents are treated differently than those owned by the students’ parents.
It is worth noting that student loans often make up a significant portion of financial “aid” packages, so sometimes reduced financial aid is mostly a reduction in student loans that need to be taken out to pay for school, which is a positive.
Not All Plans Are Created Equal
Some recent news articles, such as this one, have highlighted that some 529 Education Savings Accounts are not as good of a savings option as they should be because of the high fees that they charge. For this reason, it is important to try to find a 529 plan that has relatively low fees.
Making 529s Accessible to All
Enrolling in a 529 plan for yourself or a loved one is often an excellent idea. Putting away tax-free savings and taking advantage of compound interest can make college more accessible for future students and help mitigate the crushing debt burden that the majority of college graduates are now bearing.
There are exciting initiatives taking place all over the country to expand 529 plans and increase the public’s use of them, such as the Refund529 program signed into law in New York State in 2016. However, more can and should be done to make this program more accessible to low-income families by continuing to restructure asset limits for public assistance programs and other safety nets designed to help those most in need.
Please join us in advocating for the expansion of 529 plans and a reduction of asset limit tests that impede people from enrolling in them. And while you’re at it, consider enrolling in a 529 plan yourself.