Remember the days before theinternet? It was almost impossible to access certain information, like songlyrics. People would go years singing the wrong words while insisting they wereright.
For instance, I thoughtJohnny Nash was singing “I can see clearly now, Lorraine is gone.” My husbandset me straight that it was “I can see clearly now, the rain isgone.” I suppose that makes more sense.
Now you can type a few wordsinto your phone, and Google will tell you the lyrics to any song. It’s thatsimple. Unfortunately, getting answers to financial questions isn’t always thateasy, even with the vast resources available online.
Take 529 savings plans.They’re a popular college savings vehicle, but many people misunderstand howthey work or can’t find answers to their 529 questions.
To help clear things up,here are answers to 5 of the most common questions I’ve received about thistopic.
Can my child use a 529 plan from a different state?
The fact that states offertheir own 529 plans confuses many investors. You might think you have to investin your own state’s plan, but that’s not true. While there are often advantagesto investing in-state, you can choose to invest in a 529 plan from any state.This gives you the opportunity to shop around and pick one that meets yourcriteria—a low minimum investment, low fees, and a variety of investmentoptions, for example.
So how do you choose theright plan for you? Here’s an easy 3-step process to get started:
- Find out what tax breaks your state offers. More than 30 states, plus Washington, D.C., offer full or partial state tax deductions for 529 plan contributions. However, only 7 of those states offer the deduction regardless of which state’s 529 plan you invest in. To find out how much you might save, use our 529 plan state tax deduction calculator.
- Take into account the plan’s fees and costs. The expenses associated with 529 plans vary significantly. For instance, some plans are advisor-based and, therefore, require you to pay commissions on your investments. In general, direct-sold plans cost less. To compare costs, look up different state plans on this interactive map.
- Consider the investment options available. Once you select a plan, you’ll then need to choose investments. If you’re looking for an easy way to manage your investments, look for a plan that offers age-based options. Similar to target-date retirement funds, age-based options automatically adjust your asset allocation over time. So as your child gets closer to college age, your investments will shift to more conservative portfolios—giving you one less thing to worry about.
What impact do 529s have on financial aid?
Because you have to declare529 assets on financial aid forms, parents often worry that saving in a 529will prevent their child from qualifying for grants and income-based scholarships.Some even try to sidestep this issue by opening the plan in the name of someoneoutside of the immediate family (like a grandparent).
How it actually works
The effect of a 529 plan onfinancial aid is minimal. And opening an account in a grandparent’s name islikely to backfire—making the child less likely to receive aid.
The reason? High income hasa much more negative effect than assets when qualifying for financial aid. Ifthe 529 plan is parent-owned, it’s considered an asset. If the 529 plan is insomeone else’s name, the withdrawals are considered income.
Here’s how it works on theFree Application for Federal Student Aid (FAFSA): Assets (including 529 plans)held by a parent can reduce need-based aid by 5.64% of the asset’s value. Thatmeans if you have $10,000 in a 529 plan, that savings could reduce aid by $564.
However, student income canreduce the amount of aid by much more. In the case of a 529 plan held by agrandparent, the money used to pay for tuition must be reported as untaxed incomefor the student on the following year’s financial aid forms. And it couldreduce the amount of aid by 50%.
Let’s say a grandparent ownsthe 529 plan and withdraws $10,000 to pay for tuition. The next year, thatwithdrawal could increase the amount the family is expected to pay by $5,000.
In the end, it may be betterfor generous grandparents to gift money to the parent-owned 529 plan.
This example demonstrateshow complicated it can be to maximize aid. It’s true that financial aid can bea big help when paying for college. But trying to arrange your finances so yourchild will be more likely to qualify for grants or other aid is trickybusiness. And counting on aid leaves you at the mercy of collegeadministrators. A better approach is to save early and as much as you cantoward college costs.
What taxes and penalties will I pay if I withdraw 529assets for nonqualified expenses?
Many people are concernedthat their children won’t attend college or will need to use their 529 savingsfor expenses not related to education.
First, keep in mind that 529plans provide a lot of flexibility. You can use the assets for tuition at acollege, university, trade school, or vocational school. You can also use itfor other higher-education expenses, such as room and board, fees, books,supplies, equipment, computer hardware and software, and internet access andrelated services.
But what if your child endsup choosing a different path? You have a few options. You can transfer theaccount to another family member or even use it yourself. Or you can leave themoney in the plan in case your child decides to attend school later (there’s noage limit).
It’s true that there arepenalties for withdrawing the assets to pay expenses not related to education.However, these penalties only apply to the earnings portion of yourwithdrawals. They include:
- Federal income tax.
- A 10% federal penalty tax.
- State and local taxes (if you claimed a deduction or credit).
Example: Youhave a 529 plan with $10,000 of contributions and $2,000 of earnings, for atotal of $12,000. Let’s say you have to take it all as a nonqualifiedwithdrawal—this, of course, would be a worst-case scenario. You’d only owefederal taxes and the penalty on the $2,000 in earnings. If you deducted yourcontributions from your state income taxes, you may also have to report state“recapture” income.
What are the benefits of saving in a 529 plan?
Here are the key advantagesof a 529 plan:
- Federal tax benefits. While contributions aren’t deductible from federal taxes, earnings in 529 plans grow tax-free and won’t be taxed when you take the money out to pay for college.*
- State tax benefits. As I mentioned in the first question, more than 30 states offer a full or partial tax deduction for 529 plan contributions.
- Control. The parent (or account owner) has control over the account. In most cases, the named beneficiary has no legal rights to the assets. As a result, parents can feel confident that the money will be used for education.
- Simplicity. It’s an easy way to save for college. And most plans let you set up automatic investments, where you link your bank account to your 529 account. This allows you to add to your savings in a convenient and systematic way. You can also invite others to celebrate your child’s milestones with the gift of education savings. The gifts are then deposited directly into your 529 plan account.
What’s a reasonable college savings goal—100% oftuition? 50%?
Any amount that you savewill make it easier for you and your child when it comes time to face collegecosts. Few of us can save 100%, so we recommend striving to save about 30% ofthe total price tag. However, even that number is difficult for many familiesto meet.
According to the mostrecent figures from Sallie Mae, most parents cover about 23% ofcosts with income and savings. The rest comes from student and parent loans,grants, scholarships, and gifts from relatives.
If you’d find it helpful tohave a specific savings goal in mind, look up the cost of a particular collegeand choose a percentage to shoot for. Then, to help meet your goal, considersetting up automatic investments or ask relatives to contribute to the planinstead of giving your child gifts.
Remember, every dollar yousave is a dollar you or your child won’t have to borrow in the future.
It’s worth the effort!
There are certain songlyrics that I will never decipher. And to me, it’s not worth the effort to lookup the words.
But for anyone interested insaving for college—whether it’s for your child, your grandchild, or anotherclose relative—529 savings plans are worth taking the time to understand.
Clickhere for the original blog article from Vanguard.