Across America, some 20 million college students return to campus. Some prepare for their future, others intend to change it. And an interesting trend is emerging – tuition costs are growing at a slower rate. According to the College Board, tuition grew an average of about 6% annually from 1990 through last year. That’s double the rate of inflation. However, this year the Labor Department estimates tuition costs have risen just under 2%. Factors include supply (more colleges), demand (less students going back to school with a healthy job market), and demographic shifts (declining birth rates). And more private schools are discounting their sticker prices – NACUBO reports that freshman are receiving higher price breaks on tuition via scholarships and grants.
Nevertheless, funding education costs has significant impact. The average cost for a four year private college is about $27,500. You’re either writing big checks – $66,000 annually 18 years from now if you have a newborn and 5 percent inflation – or graduate with student loans that compete with other financial goals – building cash reserves, buying a home and saving for retirement. Or the smarter ones start saving money early – saving $790 monthly for that newborn assuming a 5 percent return.
You have options on how to save and invest that $790. Each has its trade-offs. One popular way is via 529 plans. This article will address some of the mistakes to avoid with 529 plans. First, however, a refresher.
What are 529 plans? They help save for college and other post-secondary training on a tax-advantaged basis. There are two main types including “prepaid tuition plans” and “savings plans” and my focus will be on savings plans. The key advantage is that withdrawals of earnings (you invested X and account has grown in value) might be tax free if funds are used for “qualified education expenses” or QEE’s.
Mistake # 1 – Using “Pre-paid plans” only
Prepaid plans are losing popularity. First, tuition might be only a third of the total college expense. What are you doing to fund other costs including room and board, transportation, and others? Second, they have their limitations. What if you buy prepaid for University A, but your kid prefers U of B? What if B tuition exceeds A? Will you support his or her enrollment in B and how make up the cost difference?
Mistake #2 – Withdraw too much
You cannot use 529 plans like an ATM. Withdrawals must be for QEE’s. Ineligible withdrawals are subject to tax consequences – earnings may be taxable and 10% penalty. QEEs are generally for the school’s published “estimated costs” – tuition and fees, room and board, books, supplies and equipment. Issues arise when students live off campus (and costs exceed on campus rent and meal plans), forget to adjust for scholarships and tax credits, and fail to report school refunds. Students are advised to keep record of their expenses and segregate purchases – lunchmeat and PBR on separate bills!
Mistake #3 – Overfunding
What if there’s left over money because they came in under budget (funded for four years and they were done in two)? The owner of the 529 plan generally doesn’t lose the money, however he or she may lose the tax benefits. You may change the beneficiary (you name a grandchild after your kid graduates), or you use the funds for your qualifying secondary education expenses. And if you’ve run out of beneficiaries, you can always make an ineligible withdrawal and pay the taxes and penalty.
You have options with education funding, and each may be subject to special rules. Know where the lines are, stay inside of them, and consult your advisors and especially your CPA. Tax issues can be complicated, and I like you hate to get a letter from the IRS. Good luck!