Monday, June 2, 2008

529 College Savings Plans: Tax Advantages for Your Student

Worried about the high cost of college for your children? This concern is certainly legitimate. On average, the cost of a college education rises by twice the rate of inflation. However, the fear of a cost increase can be mitigated if parents and students are aware of the tools available to help them cover the expense.

The 529 prepaid tuition and savings plans are among the weapons parents and students can use to cover the cost of college tuition. The 529 plans, also known as “qualified tuition plans” are designed to encourage families to save for higher education. They provide incentives to save, and also allow for additional financial and tax benefits that can make the process easier for families who plan ahead. All 50 states sponsor at least one type of 529 plan, so there are options available for any citizen in any state.

Note that there is a difference between the 529 prepaid tuition plans and the 529 college savings plans. The 529 prepaid tuition plans allow parents and students to purchase credits for tuition at a chosen university and sometimes even room and board. The price of tuition, room and board is held fixed, with no inflationary changes for the duration of the investment (in other words, the cost of tuition doesn’t change for you like it does for everyone else). Most of the plans are sponsored by the state government and also have some kind of residency requirement. In exchange for meeting these requirements, the state government will provide a guarantee for the investment made in the 529 plan.

The 529 savings plans are similar to the prepaid tuition plans, with some mild variations. The plans allow an individual (usually the parent) to set up a plan for another individual (the student) with the goal of paying for the student’s educational expenses. The plans allow plenty of flexibility in choosing the beneficiary, and you can even choose yourself as the beneficiary. The funds are not guaranteed by the state or federal government and you are given an array of investment options for the funds you’ve deposited into your account.
The tax advantages of 529 plans are quite strong. While rules can vary by state, you are not typically required to pay state and federal taxes on earnings from the 529 plan. The only requirement is that any withdrawals from the plan are being used to pay qualified college expenses. Withdrawing the funds to pay for items not related to the cost of college attendance will lead to a 10% penalty in addition to any applicable federal and state income taxes.

Here is a mathematical example to help you understand the financial impact of avoiding taxation on investments in a 529 college savings plan. Assume Teresa invests $1,000 per year in her son’s 529 college savings plan from the time he is born until he is 18-years old. Also assume that her investment earns an annual rate of return of 8%, which is relatively easy to earn on a well-diversified stock portfolio (you can simply ask your investment company to give you a mutual fund that matches the risk and return of the rest of the stock market). She doesn’t engage in stock picking. She just puts her money in a simple mutual fund and leaves it alone.

How much will Teresa have contributed to the account over an 18 year period? $18,000. How much will she have available to pay her son’s tuition when he leaves for college? $37,450. That is more than double the amount she invested in the plan over the 18-year period. Not being taxed on the income gives Teresa an extra $5,000 (roughly speaking) to pay college tuition that she would not have had by investing without the tax benefits of the 529 plan.

One thing that Teresa must remember is the fact that the average tuition increase is 8% per year. So, this increase is going to match dollar-for-dollar the increase in Teresa’s investment portfolio. So, the truth is that she is going to have swim forward just to keep up with the current. This match in growth rates is what makes prepaid tuition plans roughly the same in attractiveness as prepaid savings plans. Had Teresa invested in a prepaid tuition plan (instead of a savings plan), she would have found herself paying tomorrow’s tuition at today’s prices. So, either way, she is going to pay tuition, but investing with tax benefits makes it easier.

My thoughts on the issue? Prepaid tuition plans are the safest bet, as long as you are sure that you don’t want to leave the state to attend college. While you are allowed out of the deal in most cases, there is a penalty for doing so. Savings plans are better for those who want to have a bit more flexibility in attendance options, as well as the chance to possibly outrun the cost of college tuition. Remember: Teresa earned 8% per year on her investment, but the average rate of return on the stock market has historically been around 12%. Therefore, an average portfolio over 18 years would have likely given her more than the cost of tuition.
The key is to remember that the greatest investment in this process is the one in your child. Your child’s greatest investment is the one in his/her educational future. Also, there are a litany of financial aid options available in addition to 529 savings plans. Money should not be a hurdle to building a great future.

Dr. Boyce Watkins is a Finance Professor at Syracuse University. He is also the author of “Everything You Ever Wanted to Know about College”, and “Financial Lovemaking 101: Merging Assets with Your Partner in Ways that Feel Good”. He is also the founder of, one of the top black news and commentary sites in America.

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