How to Save for College with a 529 Plan

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Every year for the holidays, as well as for birthdays and other special occasions, I struggle with what to gift to my nephews and nieces. Usually I just end up writing a check and maybe buying something small for each child (I know, boring).

This year, instead of writing a check or trying to pick out the perfect gift, I decided to give something that I feel will have more of a lasting impact. I opened up 529 college savings plans for each one of my nephews and nieces.

If you have children in your family and you also struggle with picking out gifts, this is a great option. In addition to being able to open up a 529 plan for your own children, you can also open a plan for a grandchild, niece, nephew, or even the child of a friend.  Below I’ve included more information about what a 529 plan is, how I went about evaluating which plan to select, and some of the other things to keep in mind.

money-gato-save-for-college-529-plan

529 Plan Overview

A 529 Plan is an educational savings plan that can be used to set aside funds for future college costs. Most plans are operated by a state or educational institution and provide tax advantages when saving for college (as well as other post-secondary training).

The main benefit is the tax savings on earnings, and in some cases on contributions as well. Earnings grow federal tax-free and withdrawals are not subject to federal tax (and generally they are not subject to state tax either) as long as they are used for qualified higher education expenses. In addition, many states also offer a state tax deduction for contributions made to your state’s plan.

Qualified Higher Education Expenses

In order to get the benefit of tax free withdrawals, you’ll want to check with the school to make sure which expenses are required since not all expenses qualify. In general, the following types of expenses are considered qualified higher education expenses:

  • Tuition and mandatory fees.
  • Room and board (for students enrolled at least half time).
  • Books, supplies, and required equipment.
  • The purchase of computer or peripheral equipment, computer software, and Internet access.

Who Can Contribute?

Anyone that is a U.S. resident who is 18 years or older, has a U.S. mailing and legal address, and a Social Security number or Tax ID can open up a plan.

Most state plans do not require that you be a resident of that state in order to participate. However, if your state offers a state tax deduction for contributions, then you will most likely want to contribute to your state’s plan (you may want to consider another state’s plan if the investment options are lousy or if the expenses and fees are high in your state). If your state does not offer a tax deduction, then choose a plan based on the factors that are important to you (I explain the criteria I personally used below).

It’s also important to note that the plan you choose has no impact on which state the beneficiary chooses to attend college (i.e. there are no issues with an account owner who lives in Texas and opens a 529 plan in Nevada for a beneficiary that lives in Maine and attends college in Massachusetts). There is another type of 529 plan called a “prepaid tuition plan” which may, however, restrict the choice of college to the state of the plan.

Who Can You Set up a Plan For?

As mentioned above, you don’t have to be the child’s parent to open up a 529 plan. You can open up a plan for a grandchild, niece, nephew, child of a friend, or even for yourself. Anyone who has a social security number or Tax ID can be designated as the beneficiary.

Criteria I Used to Evaluate Plans

Since I live in California, which does not offer a state tax deduction for contributions, I was in no way constrained to use the CA plan. I used the following criteria when evaluating the various state plans:

  1. Low fees – As a proponent of using low cost index funds, I personally feel that one of the most important factors when investing is to avoid investments with high costs that will eat into your returns. I focused on plans that provide index funds and other investments with the lowest fund expense ratios and no (or low) additional fees.
  2. Low minimum contribution to get started – While I wish I could shell out a few thousand dollars for each of my nieces and nephews, I was looking to initially contribute ~$500 for each child so I wanted a plan that had either no minimum or a low minimum amount required to get started. I also wanted a plan with no minimums for future contributions.
  3. Investment options – While I do manage the asset allocation in my own portfolio, in this case I was looking for something that offered age-based investment options. An age-based fund automatically adjusts the investments based on the age of the beneficiary, starting off with an allocation that’s more aggressive when they’re younger, and reallocates to safer investments as they get closer to college age (similar to how a target date retirement fund works as you near your retirement age). One advantage of using a fund like this, in addition to not having to manually manage your allocation of stocks and fixed income, is that it takes the emotion out of the decision and just rebalances/reallocates automatically.

The Plan I Chose

Based on the criteria above and my research into plans (to be honest, I didn’t spend a ton of time looking at every plan), I decided to go with the Utah Educational Savings Plan. It helped my decision that Morningstar rated the plan as one of the best 529 plans for 2016 (the Utah Educational Savings Plan was one of only three plans that were “Gold-Rated”).

morningstar-best-529-plans-2016
Source: Morningstar

This plan offers 14 investment options (four age-based options, eight static options, and two customized options) with funds from Vanguard, DFA (Dimensional Fund Advisors), the Utah Public Treasurers’ Investment Fund (a cash equivalent), and FDIC insured accounts.

The fees for the age-based investment options, which are the options I am most interested in, range from 0.17% to 0.21%, which I’d consider to be completely reasonable. This is the total fee including the expense ratios of the underlying funds in addition to the administrative fees charged by the plan. There’s an additional $12 annual Administrative Mail Delivery Fee if you want to get paper statements sent in the mail (this is waived if you get statements online). There are also no transaction charges for investment option changes (changes are limited to 2 times per year, which is a limit imposed by the IRS).

Another option I liked with the Utah plan is that the minimum investment amount is $0. This means you can set up the plan without initially making a contribution to it or just contribute a small amount to start out.

Setting Up the Plan

Setting up the plan online on the Utah Educational Savings Plan website was quick and easy. You will need to set up a separate plan for each beneficiary that you want to contribute for, though you can set up a single online account ID and have all of the plans associated with the single account. In addition to the date of birth of the beneficiary, you will also need the Social Security number for each beneficiary that you want to set up a plan for. After providing information about yourself (as the account owner), the beneficiary, and optionally a successor account owner, it’s on to selecting the investment options.

Investment Options

Below are more details on the specific investment options available in the Utah Educational Savings Plan. Depending on what state’s 529 plan you choose, the investments could be quite different both in terms of the underlying funds used as well as the options for how you select/manage the allocation of the different funds.

As mentioned above, the Utah Educational Savings Plan offers four age-based options. This includes two that are considered to be aggressive (one is a domestic fund that begins with 100% in U.S. equity funds while the other is a global fund that begins with both U.S. and international equity funds), a moderate fund (begins with a 20% allocation to fixed income), and a conservative fund (begins with a 40% allocation to fixed income). Any of these are great for a passive approach with really no intervention required.

Below is a chart showing the asset allocation at the various age brackets for the Utah Age-Based Aggressive Global option.

utah-age-based-aggressive-global
Source: uesp.org

By comparison, the chart below shows the asset allocation for the Utah Age-Based Conservative option.

utah-age-based-conservative
Source: uesp.org

The Utah plan also offers eight “static” investment options, which maintain a constant allocation of stocks and/or fixed income regardless of the age of the beneficiary (rebalanced every year on the beneficiary’s birthday). They offer options here that allow you to select an allocation all the way from 100% in equities to 100% in fixed income, or somewhere in between.

As an example, the chart below shows the breakdown of funds used in the Utah 70% Equity/30% Fixed Income static investment option. This fund uses one domestic equity fund, two international equity funds, and three domestic fixed-income funds (the same underlying funds are used in the age-based options discussed above).

utah-static-70-equity-30-fixed-income
Source: uesp.org

There’s also the option to use two customized investment options where you can select the asset allocation for each of seven preset age brackets. This seems like a good option if you want to really fine-tune a custom allocation for each of the age brackets. One potential negative with this approach is that it could be more expensive as the customized funds have fees that range from 0.20% up to 0.60% at the higher end (I’m assuming the upper end of the fee range is if you choose the more expensive DFA funds instead of the Vanguard funds).

Other Things to Keep in Mind

Below are some additional factors to consider for 529 plans.

Impact on Financial Aid

One other consideration when setting up a 529 plan is how it will impact the student’s ability to get financial aid in the future. When it comes to calculating need-based financial aid, 529 plans are treated differently based on who the account owner is. Plans that are owned by a parent must be reported on the FAFSA and are considered parental assets, and can reduce need-based aid by a max of 5.64% of the asset’s value. If the student is the owner of the plan, the impact is significantly larger at 20% of the asset’s value.

Plans owned by non-parents such as a grandparent, aunt/uncle, etc. do not need to be reported on the FAFSA as assets. However, in the year after they’re withdrawn to pay for educational expenses, they must then be reported on the financial aid forms as untaxed income to the student. Student income is assessed at 50%, so for every $1,000 that is paid by a non-parent, it reduces eligibility for aid the following year by $500.

A potential strategy to maximize aid would be to draw down all parent-owned 529 plans in earlier years (which then reduces their assets for the following years on FAFSA) and wait until the student’s final year of college to withdraw non-parent-owned 529 plans.

Changing the Beneficiary

As the account owner, you have control over who the beneficiary of the plan is so you can later assign a new beneficiary if circumstances change. For example, if for some reason the child does not end up going to college or the funds can’t be used (i.e. they receive a full scholarship), the beneficiary can be changed to a “qualified” family member (could be a sibling, parent, aunt, uncle, niece, nephew, spouse of the original beneficiary, etc.).

There may be some tax consequences if a change in beneficiaries results in skipping generations. Also, some plans and/or states may treat beneficiary changes differently so it’s best to consult a tax professional in regard to your specific situation.

Conclusion

Starting a 529 plan, whether it’s for your own child or a friend or family member’s child, is a great way to save for their future. While they may not appreciate this now, they certainly will when they graduate from college and have less (or no) debt as a result.

The earlier you start, the higher the account growth potential will be thanks to the power of compounding. Also, with continued contributions for future birthdays, holidays, and other special occasions, the value will really start to grow over time.

Whether it’s a gift for some specific occasion or not, consider setting up a 529 plan for the children in your life sooner than later.

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