By TPM | May 28, 2018
Why Save in a 529 Plan?
- Compounded returns
- Tax advantages
- Reduced expected family contributions
As a dad, there are times when the cost of college feels like a ticking time bomb that starts at birth with an 18-year fuse. The journey I’m on with my kids is constantly surprising and exciting, particularly when it comes to their education, but the reality is that college expenses are rising at an unprecedented rate. A couple of years ago a study found that the average cost of tuition and fees for an in-state student at a public university for a four-year degree was $39,508, for a private school, the number was $135,010. That doesn’t even include room and board. That also doesn’t account for that fact that my kids won’t be going to school for many years and those numbers are going nowhere but up.
To help prepare for those expenses, when each of my girls was born, my wife and I have opened up a 529 account for each of them within the first few months of birth. 529 accounts are tax advantaged savings and investment accounts designed to help families plan for their kids’ education. The system was created in the Clinton administration as a way to save for college. Recently, in the Trump administration, it has been expanded as a way to save for private K-12 education as well.
Even using money automatic savings, there have been times we’ve had to adjust our 529 saving rates for our kids up or down to meet our financial goals. However, every year we’ve always managed to put something away and have been rewarded by seeing those balances grow. While there are alternative ways to save for college, here are 3 reasons I use a 529 to save for my child’s college.
DISCLAIMER: I’m not a financial professional. Don’t take these statements to be financial advice.
It’s definitely possible for my college savings to be in a true savings account. However, the returns I’d get there will be extremely low, often around 1%. That doesn’t even keep up with inflation, and college expenses are growing faster than inflation. 529 accounts should do better because those investments tend to be in mutual funds of bonds and stocks which have historically much higher returns. While there’s no way to predict what my return will be on these funds and they could even lose money, history suggests over time that I’ll do better, that it wouldn’t be out of line to expect a return in the high single digits. And if you put that money to work when your child is young, the first year’s earnings get earned on in the second year and so on, known as compounding.
One thing I do to try to improve my return is pay attention to the fees on the different options in my state’s 529. Often times there are very similar active and passive (index) funds. Over time, research has shown that on average passive funds funds tend to perform better, simply because they charge investors less.
One of the biggest reasons I go with a 529 is that it has some great tax advantages. Every state has its own 529 plan, which includes many different investment options. If you invest for college in your state’s 529 plan, you might be eligible to deduct the dollars invested on our state income tax. Around 30 states offer this deduction. I’ve lived in a couple of different states during the years I’ve been saving for my kids’ college and have been fortunate that each has offered this deduction.
In every state, the biggest tax advantage with a 529 is that the returns my investments generate will be tax free, assuming that the money goes towards qualified educational expenses. It’s kind of like a Roth IRA for education.
Reduced Expected Family Contribution
Will your you and your child be filling out the FAFSA (Free Application for Student Aid)? It’s likely since this application determines their eligibility for grants, work-study, and low-interest college loans. You’ll want to get familiar with the idea of the Expected Family Contribution, or EFC. When you fill out the FAFSA, the US Department of Education will take a look at your finances and family situation to determine how much they think you can afford to pay for college before making your child eligible for assistance. It’s a complicated formula, but here’s an important point:
- When I was a child, my parents saved for college in an UTMA (Uniform Transfer to Minor’s Account) for my college. There are still people saving this way. All the money in these accounts are considered student assets and increase EFC by 20%. If I have saved $10,000 for college in an UTMA, that will increase my EFC by $2000, meaning I’d be expected to pay $2000 more before receiving the first $1 of assistance.
- The money saved in a 529 account is considered a parent asset, and therefore would increase the EFC by just 5.64%. So in this same scenario, the $10,000 would only increase my EFC by $564 before my child would begin to qualify for assistance. That’s a big difference.
Saving for college is not easy and is in fact daunting, but for me the alternative is to leave my kids paying for school with crushing debt that will take them years if not decades to pay off. The federal government has done us a solid with 529 plans, but the earlier these plans are leveraged, the more advantageous the compounding returns can be to help with college expenses.