Back to Basics – College 529 Plans

College 529 Plans can help you complement the Post 9/11 GI Bill and pay for college

College 529 plans can help complement your Post 9/11 GI Bill and supercharge your childrens’ ability to pay for college.

This is the next article in my ‘Back to Basics’ series, and is meant for people who may have heard about college savings plans and would like to know a little more.  College planning for your children is a topic that can cover a wide variety of beliefs, options, programs, government incentives and savings vehicles.  While college planning can cover a lot of different topics, this article will focus on:

  • Defining what a 529 plan is
  • Describing the two types of 529 plans
  • Pros and cons of each 529 plan
  • Outlining how a 529 plan can be used in conjunction with other military benefits

So, what are 529 plans?

Great question.  According to the Securities & Exchange Commission, a 529 plan is: “a tax-advantaged savings plan designed to encourage saving for future college costs.”  Section 529 of the Internal Revenue Code provides for this savings plan to:

  • Be sponsored at the state level
  • Provide tax-deferred growth and tax-free gains on qualified distributions
  • Allow for greater savings than previous plans, like Coverdell (formerly known as education IRAs)
  • Allow account holders to control funds in the event the beneficiary doesn’t go to college

In other words, a 529 plan is one of the ways that the government encourages investment in higher education.  The federal government doesn’t tax income for investment that are earmarked under the 529 plan.  Each state government sponsors an individual plan, which encourages people to invest and go to college in their state.

Regardless of which type of plan you choose, there are some things to point out:

  • You don’t have to be the parent of a beneficiary to establish or contribute to 529 plans. 529 plans allow for relatives, such as grandparents, aunts and uncles, or other members, to contribute.  This is great if you have a lot of family members who want to contribute or give presents but don’t know how.
  • You control the money, even if your child doesn’t go college. Unlike the Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA), both of which revert to the beneficiary’s control when they reach legal age)
  • Rich relatives can help, A LOT!
    • Contribution ceilings: First, most 529 plans have very high contribution ceilings.  For example, Texas allows you to contribute up to $370,000 per beneficiary.  Even after the ceiling is reached, most plans allow for earnings to accrue…you just can’t contribute any more to them.
    • Special gift tax rules: Most people are familiar with the annual exclusion for taxable gifts.  If not, here it is in a nutshell:  In 2016, you can give up to $14,000 to any person without having to file a gift tax return.  Any amount above that, and there are gift tax implications.  For 529 plans, there is a special rule that allows you to gift up to 5 year’s of contributions at once.  The donor will still have to file a gift tax return, but this is great if you have a rich uncle (or grandparent) who wants to help you supercharge your child’s savings.  I would advise anyone making such a large gift to seek the advice of a tax professional, but anyone who is in a position to do this is probably already working with one tax professional.

Types of 529 plans

There are two types of 529 plans:  prepaid tuition plans and college savings plans.  Let’s break down each one and look at the pros and cons.

Prepaid tuition plan:  A prepaid tuition plan allows you to purchase credits from a state’s sponsored plan, which would then allow you to send your child to a public school from that state.  Depending on the plan, you lock in tuition at a certain price, then you make payments for a certain time.  This allows you to plan and execute a long term budget for the tuition plan.  Here are some of the pros and cons:

Pros:

  • Tuition stability. As long as you continue paying into the plan, you’re guaranteed to lock in tuition at current or near-current rates.  This does offer peace of mind for people concerned about inflation.
  • Investment risk. Since prepaid tuition plans purchase tomorrow’s tuition at today’s prices, you do not invest in the market.  Most state plans are guaranteed by the full faith and backing of the respective state, or that there is a state sponsored process to ensure that your plan keeps pace with tuition.  However, some plans offer no such guarantees, so you will want to make sure that the plan you’re paying into does.
  • Supplemental plans. In addition to prepaid tuition, some states offer supplemental plans.  Supplemental plans can include expenses such as room and board, meals, or administrative fees that seem to find their way into those college bills.

Cons:

  • The biggest con is that tuition stability comes at the expense of flexibility.  If your child chooses to go to a college that is not covered, you can pull your money out of the plan.  However, you’ll most likely find that the real rate of return (return after inflation) is very low.  For people who are not attached to their state of residence (like military families who PCS often), this lack of flexibility is very important to consider.
  • You might find that some plans do not actually protect against inflation, but force you into paying more at today’s prices than you might on your own.  For example, the Florida Prepaid Tuition plan came under fire several years ago for having prepaid tuition rates that ended up costing more than the projected tuition itself!  You’ll want to do your own due diligence before you start paying into the plan.
  • If, for some reason, you pull your money out of a plan, the plan will refund your contribution.  However, most plans will only give you your original contribution, with a reduced amount of interest.  You can also expect to pay a cancellation fee.

College savings plan.  A college savings plan allows you to save money into a plan, which can then be used to pay qualified college expenses.  Unlike a prepaid tuition plan, a college savings plan can be used to pay for a variety of non-tuition expenses, such as books, fees, room and board, etc.  While you do not lock in tuition at a certain rate, a college savings plan offers flexibility and the opportunity to make investments that may maximize long-term value.  Let’s look at the pros and cons:

Pros:

  • Flexibility. As long as you continue paying into the plan, you’re guaranteed to lock in tuition at current or near-current rates.  This does offer peace of mind for people concerned about inflation.
  • Investment options. Most savings plans allow for a broad variety of investment options.  Many of these plans include target-date funds (similar to TSP’s Lifecycle Funds).  Target-date funds automatically rebalance towards more conservative investments as you get closer to withdrawing your money.  This allows you
  • Supplemental plans. In addition to prepaid tuition, some states offer supplemental plans.  Supplemental plans can include expenses such as room and board, meals, or administrative fees that seem to find their way into those college bills.

Cons:

  • Inflation risk. The benefit of a prepaid plan is the exact weakness of a savings plan.  While you are able to control your investments, you are responsible for ensuring that they are able to cover college costs.  If you underestimate college cost inflation, you might find that your savings plan isn’t enough to cover all the costs.
  • Investment risk. Having control over your investments means that you are ultimately responsible for investment risk.  While target-date funds help to mitigate this risk, there is no guarantee that a ‘black swan’ event won’t disrupt your planning.

To summarize, the relationship between prepaid tuition plans and college savings plans comes down to risk.  In this regard, this relationship is very similar to that between defined contribution and defined benefit retirement plans.  Your choice should reflect how comfortable you are with the relationship between risk, opportunity, and flexibility.

Coordinating 529 Plans With Other Options

Many people consider 529 plans as an ‘all or none’ type solution.  Having access to the post-9/11 GI Bill opens a whole lot of options to ensure that you are comfortable with your college planning.  Below are a couple of ways to ensure that your 529 plan achieves the best benefit:

  • Talk to your kids early and often about college. The number one factor in making sure you can afford college is communication.  What do you talk about?  For starters, talk about setting reasonable expectations.  Discuss what resources you’re willing to set aside, and what they’re expected to contribute.  Be sure to emphasize that cost is a consideration.  Telling your child that you’re willing to pay for whatever they want to do will lead to an uninformed decision.  We don’t do it when buying their first car, so why should you do it just because you think education is important?  If your children know that cost is a factor, you might be surprised at how they approach college.  Also discuss the importance of responsibility.  If your children know that they are ultimately responsible for their education, they’ll take the responsibility of paying for it more seriously.  If they think their parents are paying the bills and taking care of everything, they might not.
  • Discuss the importance of high school success. While we all strive to maintain a balance as parents, our children should know that there are plenty of high school opportunities that can mitigate college costs.  Dual enrollment, AP courses, varsity sports, community involvement, and extracurricular activities can help your child eliminate easy courses or obtain scholarships that help mitigate your out-of-pocket costs.
  • Community college could help considerably. Most states allow for the transfer of community college credits to public state schools.  The opportunity to pay 30-50% less for the same course is a no-brainer.  Encourage your children to look into this opportunity.
  • Educate your children on the GI Bill. If you have more than one child, or you’ve already used some of your benefit, you might need to figure out how much you plan to give them.  Make sure they understand how GI Bill benefit should be used for the biggest bang for your buck.  A semester of community college is covered the same way as a semester of a master’s program, so you should save the GI Bill for the most expensive one.

Conclusion

At the end of the day, you should choose the 529 plan that makes the most sense in your family’s situation.  Early in your parenthood, take the time to figure out how that plan makes sense for you.  Stick to the plan, even though it might not always be easy.  As always, please feel free to follow this blog or contact me at:  [email protected], if you like this blog, have concerns or questions, or have a topic that you would like for me to address.  Until next time, take charge of your life!

 

About Forrest Baumhover

I'm a career naval officer, and a fee-only financial planner. Half-way through my career, I discovered that I had a passion for financial planning, and have pursued this as my second career. My specialty is working with military professionals who are looking to separate or retire from the service, and who feel they need some professional guidance to make sure they're on track.
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6 Responses to Back to Basics – College 529 Plans

  1. Cherie says:

    Disabled veterans of any rating percentage should also be aware of state-sponsored tuition benefits available to children. For instance, California offers a tuition waiver for public universities (even if the parent/veteran does not live in CA). Forms must be completed each year and requirements on minimal level of parental financial support.

    https://www.calvet.ca.gov/VetServices/pages/college-fee-waiver.aspx

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