3 Things You Should Know About… GIVING THE GIFT OF EDUCATION (part 2)

During this magical time of year, I hear a lot of questions about making educational gifts. So I’m breaking up my “3 Things You Should Know About…” blog into 3 parts to address the 3 Most Common Savings Gifts. Wednesday’s post, Part 1 addressed government savings bonds. Today, Part 2 will demystify 529 plans. Later this week, Part 3 will explore UGMA accounts, and I’ll conclude with the Top 3 Questions YOU should be asking when considering this type of gift.

 DEMYSTIFYING THE DIFFERENCES OF 529’S

 “529” refers to the section of the IRS Tax Code that allows states to establish tax-advantagedcollege payment plans. All 50 states and the District of Columbia currently sponsor 529 plans, in addition to a group of private colleges and universities. These plans come in 2 flavors: PREPAID TUITION PLANS and SAVINGS PLANS. There are significant differences between the two types. Let’s dive in, shall we?

 Flavor #1: Prepaid Tuition

 Biggest benefit: potentially cost effective

A prepaid tuition plan lets you purchase units of tuition for any state college or university at today’s prices. In other words, these plans allow you to “lock in” the price of tuition and fees at today’s rates. Imagine how happy you would be if you were paying 1990’s gas prices at the pump today, instead of today’s prices, and you can see the significant economic benefit to these plans.

 Biggest complaint: limited flexibility and control

Note that these plans are administered by the state, so the state calls the shots on how the money is invested (and therefore how viable the plan is). This became a concern for some states’ plans during the recent economic downturn. The state also controls whether or not the plan is open or closed to new contributions, and when. Kind of like an “Open Enrollment” period for your employee benefits at work, but potentially more wide-reaching. (In Texas, for example, the original Texas Tomorrow Fund closed in 2003. A new version called the Texas Tuition Promise Fund re-opened in 2012, but during the 9-year gap, the state did not offer a prepaid tuition plan.)

There are options if Junior doesn’t end up going to college, such as transferring the account to another beneficiary or requesting a refund, but they are rather limited; these plans really are intended to encourage saving for college education. And while you can use these plans at many colleges and universities, it’s generally most advantageous if the beneficiary attends an in-state public university. So, if you’re unsure about how you want your gift to be used in the future, there may be better options for you.

 Other Interesting facts:

  • You purchase units, not actual dollars, in a prepaid tuition plan. These units will often transfer between different schools (public or private, or between different states), but not always on a 1-1 basis. For example, 1 unit for a public university in Texas might pay the equivalent of half a unit for a public university in Illinois. The difference has to be made up out of pocket by the student (or parents).
  • In July 2006, the rules changed regarding how 529 plans are treated with regard to financial aid. Previously, a prepaid tuition plan had the HIGHEST impact on Financial Aid eligibility, because it was considered a “Resource” rather than an “Asset”; therefore, you saw a dollar for dollar (or 100%) reduction in aid. Now, both prepaid tuition and college savings plans are viewed as a parental asset instead, and calculated at a maximum 5.64% rate in determining the student’s Expected Family Contribution. (Note that we are only talking about Federal financial aid rules here. Each school also sets its own rules when handing out need-based scholarships.)
  • Funds cannot be held in a 529 indefinitely. This depends on the rules of the plan, but in Texas, for example, you must use the funds or request a refund within 10 years of the beneficiary’s expected high school graduation date (active duty military time is the exception).

 But wait! There’s more! Let’s talk about Flavor #2 of the 529 world…

 Flavor #2: Savings Plans

 Biggest benefit: flexible opportunity for tax free growth

This version is an investment plan that allows you to choose the company you invest with, the investments you own, and the strategy for your investing. This plan is also called an “Educational Roth” because if you withdraw the money for qualified education expenses (as defined by the IRS), then you pay NO tax on the earnings (like a Roth IRA). Funds withdrawn for nonqualified expenses may be subject to taxes and a 10% penalty.

Overall, this type of plan has more flexibility than prepaid tuition plans. While it is still intended to fund a college education, open enrollment is all year; there are no residency requirements and no age limits; and money can be used for a variety of education-related expenses, including tuition, room and board, and potentially books and computers. Also, using the funds in this type of plan is not affected by where the student attends college. An investor can live in Texas, invest in a plan from Nevada, and send a student to college in Florida, without adverse consequences to the value of the investment. As long as the money is used for educational expenses (as defined by the IRS), you can enjoy the tax-free benefit.

 Biggest complaint: potential for high costs

You need to do your homework (or work with a professional who will help you do it) when considering these plans. Not all are created equal. Some are sold through brokers to whom you pay a commission, and some are sold “direct” which means you buy them directly from the fund company with no broker involved.

In any case, when choosing one of these plans, be sure to look for: 1) annual maintenance fee; 2) underlying fund costs; 3) advisor sold commission rates. There are several websites where you can compare plans side by side to help you make smart choices; http://www.savingforcollege.com/ and http://www.collegesavings.org/ are two that are worthwhile.

 Other Interesting facts:

  • You’re the boss: Note that these plans are sponsored by the state, but not administered by them, so the owner (YOU) decides on how the money is invested. And now we’re talking about actual dollars now, not tuition units. That’s why it’s so important to research your investment options and fees for this type of plan.
  • You don’t have to invest in your own state’s plan; you can (and probably should) shop around. If you live in a state that charges state income tax, there may be tax advantages to purchasing your state’s plan.
  • Question the age-weighted investment option. This option has become very popular, which is why I mention it. For some investors, it’s a great idea, because it puts the risk level on “autopilot.” But “autopilot” can sometimes be more risky than you think. Here’s how it works: When the child is young and there is more time to invest, the account is weighted more aggressively. As the child approaches college age and is getting ready to tap into the money, the account becomes weighted more conservatively. Logically this makes sense, but be careful: first off, this automatic plan doesn’t take into account what is going on in the market. Let’s say the beneficiary hits another birthday when the market is in the dumps. The autopilot plan may sell off some great growth investments and dump the money into expensively priced bonds, locking in a loss. In an account with a relatively short time horizon (18 years or so), bad timing could really hurt. Secondly, it may or may not make sense to allocate on this timeline: what if your child attends community college for the first 2 years, and you don’t need to tap into the 529 funds until later? You could miss out on a few more years of growth.

 RESOURCES: Great place to start: find clear explanations and a helpful side-by-side chart comparing prepaid tuition plans and college savings plans here: http://www.sec.gov/investor/pubs/intro529.htm

Beware outdated information when performing online searches! I found lots of outdated articles out there. Rules and laws change frequently, but not all websites are kept up to date. Check the publication date or ask a professional if you are unsure.

Stay tuned for the next post: What in the world is a UGMA? And why should I care?