“There is no greater goal for a person than to aspire to know more about the world around them. There is no better hope for a parent than that their children should be presented with the opportunity of meaning and success.”

The Great Promise of Education

It is a noble endeavor to understand new things, to search out knowledge, to expand your horizons in the search for truth. It is also a very practical pursuit, in that knowledge has proven time and again to produce returns both in economic and in personal terms. Understanding the world is the first great step to both social responsibility, and economic prosperity.

College has gotten expensive. You know that by now. It is not getting any cheaper. Like taxes and death, rising costs of education have become one of those horribly reliable certainties. Still, not all is lost. Astute financial planning allows you to substantially reduce the direct cost of education for both yourself and your family. 

See the article and video below in order to better understand the various educational savings vehicles, so that you can be effective in your savings approach to the cost of college.

 

The 529 Plan

If you are putting aside money for college (either for yourself or a family member) there are savings options that produce tax advantages. 529 plans are organized by individual states for the specific purpose of encouraging educational savings. In the United States, though 529 plans are organized by individual states, the federal government recognizes the savings and offers tax advantages to distributions from those accounts. And while 529 plans are the best educational savings option for many people, some individuals will be better served by other savings options.

A recurring theme with investment options is that there is generally no universal “good” or “bad” investment plan. There are rather a number of different options that produce different levels of risk, return, and tax implications. Some produce more reliable returns, but involve higher costs to maintain. Some are highly volatile, but have the potential to outperform. The question is not whether something is “good” or “bad,” but whether it is more or less efficient at helping you to achieve your particular goals.

529 Plans are State plans with Federal Benefits

The first complexity with 529 plans is that they are not directly related to the federal government. Each state has the option of establishing and regulating its own plan. The federal government has a few basic requirements for the state plans that allow for federal tax benefits. Adding a layer of opaqueness is the fact that many states provide several different types of plans (a quick search yielded me 111 different state offered 529 plans).

You are not required to select a 529 plan from your resident state, and (in general) the money from any 529 plan can be distributed for expenses at any accredited college (be sure to verify this applies to the specific plan that you are interested in).

Although you could, say, live in Colorado and invest in a Texas 529 plan, in many instances it makes sense to invest in a 529 plan in the state that you pay taxes in. Different states have different rules as it relates to the tax exempt status of contributions to 529 plans. With at least 111 different 529 options, sticking to those options from your particular state has the advantage of narrowing down the list. If you dislike the specifics of the plan offered by your state (or if your state does not offer a plan at all) you are generally free to invest in other states plans.

529 plans are largely similar to 401Ks, though (in general) a bit more restrictive: the plans offer a limited set of index/mutual funds to choose from. This provides built-in protections to the 529 architecture that benefit inexperienced or passive investors. For those who prefer a hands on approach, 529 plans may prove a bit stuffy.

College Pre-Paid Tuition

Colleges themselves may offer 529 plans which allow for the pre-payment of tuition. In some cases this means that you can lock in current tuition rates for future expenses. Given the significant increase in educational expenses over time, this can be appealing. In some cases these plans allow for the money to be applied to another college or university if your child decides to go somewhere else (in this instance, the tuition rate would not be locked in).

A couple things need to be mentioned about these plans: they are obviously designed to encourage enrollment at a particular university, and they do not guarantee acceptance at the campus—your kids still have to meet the admissions standards in order to be accepted. And while paying tuition at current rates has a nice feel to it, there are risks associated with this as well: educational expenses have averaged 8% inflation per year, around the same as the S&P 500 averages in capital gains. This means that in investment in a 529 plan will have a good shot at growing at the rate that tuition increases. 529 plans, by not being locked into a particular college, provide flexibility that pre-paid tuition does not.

Tax Implications

For most people the current long-term capital gains rate stands at 15% (if you are in the vast majority, making between $40,001 and $441,500; below this long term capitals gains is tax free, above it is 20%). If you had the foresight (and ability) to invest $10,000 in your kids account at the time of their birth, at a modest 8% per year rate of return you would have $40,000 in the account by the time they were ready for college. The first $10,000 has already been taxed by the federal government (contributions to 529 plans are after tax), while the $30,000 in gains has not.

If the investment was outside of a 529 plan, you would have to pay a minimum of $4,500 in capital gains taxes (I will be using the 15% rate for simplicity). Each state taxes capital gains differently (California adds up to 18% on top of federal capital gains rate; Texas, does not tax capital gains). So, if you live in California (and are in the top tax bracket) you would have to pony up ten grand in taxes outside of a tax free savings plan. Ouch.

And while the federal government does not allow tax deductions on contributions to 529 plans, some states allow both: tax free money going in and coming out.

Some quick math makes the advantages of these plans concrete. We already noted that an 8% return would result in $30,000 worth of earnings on top of the original $10,000 in principle. Depending on the state that you live in, you will save between $4,500 and $10,000 on capital gains due to tax free distributions from a 529 account if you invested 10,000 for 18 years at 8%.

529 Restrictions

There is no such thing as a free lunch. The 529 money comes with some caveats that create penalties in the event that the funds are not used for the stated purpose of education. If – for whatever reason – the money is not needed for educational purposes, 529 participants would be subject to a 10% federal withdrawal and income taxes on the gains (in our example, $30,000). California adds another 2.5% to the penalty. Other states vary, and if you received state tax deductions on contributions count on having to pay those deductions back.

It should also be noted that there are a number of exceptions which eliminate the penalty:

• A beneficiary dies or becomes disabled

• A beneficiary receives a tax-free scholarship

• A beneficiary receives educational assistance through a qualifying employer program

• A beneficiary attends a U.S. Military Academy

• The qualified education expenses were used to generate the American Opportunity Tax Credit (AOTC) or the Lifetime Learning Tax Credit (LLTC)

And if the beneficiary of the 529 plan does not qualify for one of the above exemptions, rules allow for a change in beneficiaries without penalty. The new beneficiary can be ANY family member: another child, cousin, grandparent, parent, aunt, stepfather—anyone that you are related by blood, adoption, or marriage to .

IRAs for education

How old will you be when your children are entering college? If you are (or will be close to) 59 ½ years old—as long as you are opening the account more than 5-years from when you will need access to the funds—open an IRA. It is really that simple.

IRAs allow penalty free distributions for money held in an IRA account for at least five years, once you have turned 59 ½. You can use that money for anything, including an education fund. So the penalties associated with a 529 if your kids decide not to go to college are irrelevant. Added to this advantage are the normal advantages that IRA’s have over pretty much every other type of savings plan.

Even if you are going to be younger than 59 ½ when the funds are needed, IRAs can still be the better option: education expenses are one of several exemptions to early withdrawal penalties (i.e. there is no 10% penalty for early withdrawals from IRAs for qualifying educational expenses). Depending on the type of IRA (Roth or Traditional) there may be some tax implications, but in many instances the IRA world offers superior flexibility when compared to 529 plans. Click here for expanded information on Traditional and Roth IRAs, including how they can be used as education savings plans.

Click the contact button and shoot me an email if you have any questions!

-Stan

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