Tuition and other higher education expenses, including at public universities and colleges, have increased relentlessly for many years. Today, a college education represents one of the major expenses in an individual’s lifetime. As with other such expenses, meeting the cost of a college education requires long-term savings and a financial strategy. Given that savings properly invested grow over time and that such growth is compounded, the sooner you start, the better.
Fortunately, as opportunities for higher education have multiplied, so have the options for meeting the financial challenge of higher education expenses. There are, of course, scholarships, loans, and opportunities for students to work. But as children and their parents prepare for their contribution to college expenses by long-term saving, there are many choices.
That is good, but, at the same time, all plans for building a fund to help pay for college are different. That requires understanding your choices and that the right choice will depend upon a lot of various factors. There is no plan that is best for every student and family in every situation.
The 529 Investment Plan
What are called “529 plans” are a good example of the choices that students and families should consider. Yes, 529 plans are popular, but like other plans, they have their pros and cons.
The name “529” comes from a section of the Internal Revenue Service (IRS) Code created in 1996 to extend nationwide the kind of tax advantages some states offer college savings plans. (You can think of 529, an application to education of the thinking that created the IRA for retirement savings. The principle is the same, and there are specific similarities and, well, of course, differences.)
Even under the 529 rubric, there are two different types of the plan (and different details of each in different states):
Advantages of 529 Plans
Some of the advantages of a 529 plan include:
- Lock the tuition rate: On the “pro” side, prepaid tuition plans have the advantage of letting you lock in the present tuition rate at the college or university of your choice, even if the student is a decade away from college age. Thus, you are protected against constantly increasing college expenses. As you save for college by prepaying, the tuition increases year after year, not increasing the total amount you must save. If you know when you set up the plan and what institution the student wants to attend, a prepaid tuition plan is a distinct advantage.
- Get tax advantages: Savings plans under 529 enable students and families to set up a savings/investment account for college expenses and watch it grow over the years. You usually do not have to pay federal taxes on the plan’s earnings if the money is used to pay “qualified” higher-education expenses (tuition, board and room, and books). This is a powerful tax advantage, and the funds can be used at any college or university in any state.
- Change beneficiaries: In addition, changes in the 529 plan now have increased their flexibility. You are permitted to use some money to pay for private secondary education. And if the student for whom the plan is created decides not to attend college, you can change the beneficiary of a plan to support another child’s education or even go back to college yourself. Plan funds can also be used to pay off the debt that students have accumulated in paying for college.
If you decide to choose one of these plans for college savings, you must investigate the specific features of the plan in your state. Although all 529 plans share the federal tax advantage (and the restrictions that come with it), the details of specific plans can vary greatly.
Disadvantages of 529 Plans
You also should decide before choosing a 529 plan if its particular benefits match your family’s situation, the student’s plans, your investment preferences, and much more. There are other types of college savings plans with other advantages if you decide that for you, the “pros” of a 529 are outweighed by “cons” such as these:
- The cost of starting a 529 plan: Both types of 529 accounts have some upfront costs. When you set up a prepaid tuition plan, you are buying credits to pay for college courses and doing so now, in advance of the student’s attending college. Costs could start at around $200 a month to prepay tuition at a public university, and that does not pay other expenses such as room and board. Specific monthly contributions depend upon the institution and the state where it is located. Most 529 savings plans require an initial minimum payment (for example, $500) when you set up the account. In most states, you also will have to make a minimum monthly contribution to the account.
- Reducing the amount of other student aid: Direct federal aid to students for higher education expenses is based on a formula that includes a family’s financial resources from which their contribution to higher education expenses can be made. If a student is eligible for federal aid, the amount could be reduced because the family resources include your 529 savings. You might avoid this downside to a 529 savings plan by not putting it in the student’s name but in your name as a parent. Then, the savings are not included among the financial resources available to the student for college expenses. Also, the ability to switch the beneficiary of the savings plan means a plan created in the student’s name can be changed to your name. It may be worth taking that step if it enables the student to obtain more aid from other sources.
- Penalties for withdrawals, not for qualified educational expenses: If you withdraw funds from your 529 savings plan to pay for “ineligible” college expenses such as transportation to the school or a car to use at school, the withdrawal will be income on which you must pay tax to the IRS. And similarly to an IRA, there is a 10 percent penalty, in addition, to ineligible withdrawals.
- Penalties for premature withdrawals: Another restriction on 529 savings plans has to do with the timing of the withdrawal of funds. Yes, you can withdraw funds when they are needed for qualified educational expenses, but IRS regulations interpret that to mean you withdraw the funds only in the year you pay the expense. If you withdraw the funds too soon, therefore, you have made an “ineligible” withdrawal. One further note: If you withdraw more than $14,000 to pay tuition in a given year, you may be required by the IRS to pay a gift tax on it.
- Control over the investment of your funds: When you set up a 529 savings account, you are putting the money with a plan manager selected by your state. For example, TIAA, the long-time private firm for investing the retirement savings of education professionals, manages the 529 plans of more than half a dozen states. Periodically, you can change how your college savings account is allocated among the offered investments (stocks or bonds, for example). Still, you do not make any specific investment decisions of any kind. The growth of your college savings through capital gains and earnings depends upon the fund manager’s performance. If you believe you are the best one to choose your investments and investment timing, then the structure of 529 investment management is on the “con” side of 529 savings plans.
If the “cons” of 529 plans, for you, outweigh the “pros,” there are other well-developed options available.
