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Saving for Higher Education: Dispelling Myths about 529 Plans

| August 31, 2015
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08/31/2015: Contributed by Greg Middendorf CFP® CCPS® Partner | Wealth Advisor | Certified College Planning Specialist 

What is a 529 plan? 

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. Legally known as “qualified tuition plans,” these plans are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.

There are two types of 529 plans: pre-paid tuition plans and college savings plans.

All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a pre-paid tuition plan.

What are the differences between pre-paid tuition plans and college savings plans?

Pre-paid tuition plans generally allow college savers to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements. Many state governments guarantee investments in pre-paid tuition plans that they sponsor

College savings plans generally permit a college saver (also called the “account holder”) to establish an account for a student (the “beneficiary”) for the purpose of paying the beneficiary’s eligible college expenses. An account holder may typically choose among several investment options for his or her contributions, which the college savings plan invests on behalf of the account holder. Investment options often include stock mutual funds, bond mutual funds, and money market funds, as well as age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.

Dispelling the Myths:

Myth 1: You have to contribute to a 529 in your home state. That statement is false with regard to 529 college savings plans, in which money is invested in a portfolio of securities on behalf of a beneficiary. Any U.S. resident can contribute to a 529 college savings plan in any state. Contributing to a plan offered by your home state might offer an added bonus in the form of a state income tax deduction, but that shouldn’t be your sole consideration. If your state’s plan is subpar (with high fees and poor investment options, for example), looking at plans outside your state might be worth forgoing the tax break. 

Myth 2: You have to send your child to a school in the state where his or her 529 plan is offered. This is also false. A 529 college savings plan is fully portable, meaning that assets can be used for college expenses in any state and at some institutions abroad, regardless of which state’s plan holds the account. 

Myth 3: You can only get a tax deduction or tax credit if you contribute to your state’s plan. Usually true, but not always. In fact, residents of several states get a state income tax break on 529 contributions made to any state’s plan. Elsewhere the benefit is restricted to contributions to in-state plans, with deduction limits varying from state to state and some states offering tax credits. Here is a summary of the state’s tax laws in the Greater Cincinnati area near HCM:
  • Ohio – A maximum $2,000 tax deduction is allowed per beneficiary, per calendar year with unlimited carry forwards of unused contributions.
  • Kentucky – No tax deduction or tax credit is allowed.
  • Indiana – An income tax credit of 20% of contributions per year is allowed. This maximum annual credit of $1,000 can be claimed by an individual or a married couple filing jointly.
Myth 4: If you save in a 529 account for your child, it will hurt his financial aid prospects. This is possible, but not as much as you might think. Yes, financial aid calculations generally do take into consideration 529 assets, but money in a 529 account owned by the parents of a dependent student counts far less than assets owned by the student outside a 529 plan. In fact, non-529 student-owned assets carry greater weight in financial aid calculations than do assets held in the parents’ names. So, no – 529 accounts aren’t completely impact-free when it comes to financial aid, but the impact is relatively minor.

Myth 5: If your child doesn’t go to college, you’ll lose the money. Unused 529 money does not have to go to waste, or to the tax collector. It can be used to help pay another family member’s college costs simply by changing beneficiaries or transferring funds to the family member’s existing 529 account. And the list of potential recipients is rather long, including siblings, first cousins, parents, grandchildren, aunts and uncles, and even in-laws. If you do decide to cash out the plan entirely, you’ll have to pay federal and state income taxes on earnings, plus a 10% penalty (waived if the beneficiary dies, becomes disabled, or gets a scholarship).

Myth 6: All 529 plans are the same. This is a potentially costly mistake some investors make. Like many investment products, 529 plans may look similar from the outside, but once you get under the hood you’ll find major differences that determine how effective they can be at helping you meet your college savings goals. Fees, fund offerings, glide path (the rate at which the asset allocation switches from equities to fixed income in age-based portfolios), and even ease of use vary from plan to plan. Fees in particular can have a corrosive effect on 529 assets, and can vary not only from state to state but also within the same plan.

All 529 plans are tax-advantaged college savings vehicles. Any unqualified distribution of earnings will be subject to ordinary income tax and subject to a 10% federal penalty tax. Tax law is ever-changing and can be quite complex. It is highly recommended that you consult with a financial or tax professional with any tax-related questions or concerns. If you have any questions about 529 plans and how best to utilize them for your family, please give your HCM Wealth Advisor a call at 513.598.5120 to discuss the many available options. HCM is a Cincinnati financial and retirement planning firm.

08/31/2015: Contributed by Greg Middendorf CFP® CCPS® Partner | Wealth Advisor | Certified College Planning Specialist

Content in this article is not intended to be financial advice. Instead, we think of it as educational and financial education is important to us.

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