College savings plans let investors withdraw gains without taxes.
Saving to cover the steep cost of a university education can be daunting, but one way parents can potentially bridge that gap is by investing through a 529 college savings plan.
The plans, named after the federal tax code that created them in 1997, permits savers to invest in mutual funds and withdraw the gains free of federal taxes as long as the money is spent on college expenses. The tax benefits and potential returns from investments can offer a better alternative over time than simply socking away money in a bank account or certificates of deposit.
Assets in 529 plans grew 9 percent last year to $218 billion, fueled by net inflows and market gains, according to Morningstar. Still, some two-thirds of Americans are not familiar with the plans, according to a survey earlier this year by financial services firm Edward Jones.
“If you have kids or grandkids, and you believe that college education is important, a 529 college savings plan can be a really good option for you,” says Danae Domian, a principal at Edward Jones.
Here are a few tips to consider when investing in a 529 college savings plan:
Find the best plan for you
Many states offer a 529 college savings plan, and although they differ in some respects, each enables investors to use investment proceeds to pay for college costs without having to pay federal taxes on those gains. Washington does not offer a 529 college savings plan, but it does operate a unit-type prepaid tuition program (GET) for state residents that is currently closed for new customers.
You’re not limited to investing in your own state’s plan, but keep in mind that most states also offer their own residents a state tax deduction or credit (though that matters less in Washington, which doesn’t have a state income tax). Some also throw in matching grant programs or scholarships.
You’ll also want to consider which plan offers the most attractive investment options. Some state plans include a mix of funds from several investment firms, such as Fidelity, Vanguard or T. Rowe Price. Others will only offer plans managed by a single investment firm.
Additional information and state-by-state plan comparisons can be found on Morningstar’s website: 529.morningstar.com/state-map.action.
Get started early
Although no investment plan is without risk, the earlier you begin investing, the greater the likelihood that you’ll be able to weather market swings and reap a larger return.
And you’ll need as much time as possible, given the historic growth in college costs.
Consider that the average tuition, fees and room and board for private, nonprofit four-year schools for the 2014-2015 school year was $42,419, a 3.6 percent increase from the previous year, according to the College Board. At public four-year schools those costs added up to $18,943, or an increase of 1 percent.
That’s faster than the U.S. rate of inflation, which has been at a trickle of 0.2 percent through the 12 months ended Aug. 31.
To get an idea of how much your kids’ college education might cost, try the calculator at Savingforcollege.com. The Department of Education also has tools to help gauge college affordability: collegecost.ed.gov/catc.
Know the risks
Historically, stock and bond investments have produced greater long-term returns than bank accounts. But taking the investment approach to saving for college can expose investors to losses.
Nearly 90 percent of 529 plan portfolios suffered losses in 2008 when the financial crisis pummeled Wall Street, according to Savingforcollege.com.
“With college savings plans you don’t have a guarantee of keeping up with inflation,” says Leo Acheson, an analyst at Morningstar, which puts out an annual ranking of 529 plans.
Parents can be more conservative in their investment approach with 529 plans, though the trade-off may be that they don’t reach their savings goal.
For the set-it-and-forget-it investors, all 529 plans offer investment portfolios that take into account the number of years before the child goes to college. When the child is young, the portfolios invest heavily in stocks and over time transition into less risky holdings.
Hands-on investors can select plans that enable them to pick their own funds and rebalance as they see fit. The IRS limits the number of changes you can make to two a year, Acheson notes.
Consider plan fees
Some plans are “direct-sold,” meaning that parents can open accounts directly through an investment firm or the state plan administrator. “Adviser-sold” plans are available through financial advisers. They generally charge higher fees than direct-sold plans but come with professional advice.
Direct-sold plans account for 52 percent of 529 plans, according to Morningstar.
College 529 plans also typically charge higher fees than mutual funds. But that gap has narrowed in recent years. About half the plans also charge an annual account maintenance fee which averages less than $20 a year, Acheson says.
Investors who withdraw funds from their 529 accounts for anything other than college costs will have to pay federal income tax on the earnings portion of the plan funds as well as a 10 percent penalty, in addition to possible state fees.
Get the family involved
Anyone can contribute to a 529 plan for a single beneficiary. So parents can set up an account and invite relatives to pitch in.
Contributions to a 529 plan are considered gifts by the IRS, which currently limits gifts to $14,000 annually per donor, per beneficiary. For example, two parents can each gift the same child $14,000, or a combined $28,000 per year, without triggering a gift tax.
There is a maximum contribution limit per child over the lifetime of a 529 plan. It varies by state, but it’s usually more than $250,000.