Financial/Legal

Planning for future college expenses with 529 accounts


 

Financial planning for families can involve multiple investment goals. The big ones usually are investing for retirement and for your children’s college expenses. With any investment strategy, once you have identified an investment goal, you will want to utilize the right investment account to achieve that goal. If investing for future college expenses is your goal, then one of the investment accounts you will want to utilize is called a 529 plan.

Michael R. Clancy, director of financial planning, Drexel University, Philadelphia

Michael R. Clancy

What is a 529 plan?

A 529 plan is a tax-favored account authorized by Section 529 of the Internal Revenue Code and sponsored by a state or educational institution. These plans have specific tax-saving features to them, compared with other taxable accounts, which are listed below. To begin with, there are two types of 529 plans: prepaid tuition plans and education savings plans. Every state has at least one type of 529 plan. Additionally, some private colleges sponsor a prepaid tuition plan.

Prepaid tuition plan

The first type of 529 account is a prepaid tuition plan. These let an account owner purchase college credits (or units) for participating colleges or universities at today’s prices to be used for the student’s future tuition charges. The states that sponsor prepaid plans do so primarily for the benefit of their in-state public colleges and universities. Things to know about the prepaid plans: States may or may not guarantee that the prepaid units keep up with increases in tuition charges. The plan also may have a state residency requirement. If the student decides not to attend one of the eligible schools, the equivalent payout may be less than had the student attended one of the participating institutions. There are no federal guarantees on the state prepaid plans and they are not available for private elementary and high school programs.

Education savings plan

The second type of 529 account is an education savings plan, an investment account into which you can invest your after-tax dollars. The intent with these accounts is to grow the balance for use at a future date. These are tax-deferred accounts, which means each year the interest, dividends, and capital gains created within the account do not show up on your tax return. If the funds are used for a “qualified” higher-education expense, then gains on the account are not taxed upon withdrawal.

As with most investments, the longer your money is invested, the more time it has to grow via accumulated interest, dividends, and appreciation. The larger the growth, the larger the tax benefits. This offers a tremendous advantage for a high-income and high-tax bracket household to invest for future goals (such as private school tuition or college expenses). By contrast, if you had invested in a fully taxable account, you would be subject to taxes each year on the interest, dividends, and capital gain distributions. Also, with taxable accounts, your investments would be subject to capital gains tax on the growth when they are sold to pay for those future expenses.

An account owner may choose among a range of investment options that the 529 plan provides. These are typically individual mutual funds or preformed mutual fund portfolios. The portfolios may have a fixed allocation percentage that stays the same over time or come “age-weighted,” meaning the investment allocation becomes more conservative the closer the student gets to college age when withdrawals would occur. This is a similar approach to the “target retirement date” offerings one sees in retirement accounts.

If one is using the 529 account for the student’s elementary or high school years, the investment time frame may be shorter and necessitate a more conservative approach, as the time for withdrawals would be nearer than the college years. As with most investments, the account can lose value based on investment performance.

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