Philip E Laube, CPA MISST
As a CPA, I get a lot of tax questions. One of the most frequent questions I receive is about 529 plans. 529 plans are one of a few methods to save for college that offer some unique tax advantages. Also available are Coverdell ESA accounts and certain savings bonds. So which one is right for you?
First a little background on the options:
529 plans are named for the section of the tax code that created them. In general they offer tax free growth of savings to be used for “qualified” college expenses of the beneficiary. The funds are put into the plan after tax. There are two types of 529 plans, prepaid plans and savings plans. As they sound, prepaid plans allow the owner to purchase tuition at participating schools at today’s rates (sometimes with a discount) and redeem it in the future. Savings plans work more like a investment account. The advantage to prepaid plans is that they offer a pretty certain hedge against the rising costs of tuition. Private school tuition has been increasing at a rate of 4.5% to well over 5% in the last few years. The disadvantage of these plans are that they are generally limited to tuition at the participating institutions. Savings plans are sponsored by a state, but have much greater flexibility in terms of where they can be used, but growth is subject to the investments of the plan. Risk of loss on the underlying investments falls to the investor (you).
Coverdell ESA accounts work similar to 529 savings plans. There is a limit to the annual contribution to these plans. There is a good summary of the differences of these three types of plans at Fool.com (http://www.fool.com/college/compare.htm).
Savings bonds (http://www.finaid.org/savings/bonds.phtml) are frequently left out of savings contributions, but I-Bonds offer some unique advantages. I-Bonds earn a very attractive rate of interest that could be compared to the prepaid plans, but also have the flexibility of use similar to the savings or ESA accounts.
So which is right? There are several things to consider when determining the best way to save for college. They include:
Time – The amount of time before these funds are needed should play a key decision in which option is best. ESA and 529 savings plans may invest in the equity markets as well as fixed income markets. Over time equities have out-performed fixed income investments by several percent, but are subject to greater risk of loss. 529 prepaid plans and savings bonds offer protection against investment loss.
Flexibility and Control –529 prepaid plans are generally limited to the participating schools. The ESA accounts may offer less control for the investor after the student reaches a certain age (http://money.howstuffworks.com/personal-finance/college-planning/financial-aid/5295.htm). Also while all options allow for some transfer of benefits should the intended student not attend college, this is also a consideration.
Taxes – I always tell people not to make any financial decision based solely on the tax consequences and that is why this is not at the top. There are other options of education benefits such as the Hope and Lifetime Learning tax credits and the tuition deduction. In general, one may use a combination of these, but remember – you can’t count both towards the same costs. If qualified school costs are $10,000 and you use $9,000 of a 529 plan against the cost, then only $1,000 of costs are eligible for the tax credits or tuition deduction. Non-qualified expenses generally include room, food and books. Remember that the tax advantage is received when the money is spent. Think about what your tax bracket is likely to be then vs. now.
There are a lot of factors to consider when deciding if a 529 or other savings plan is right. It’s never simple, unfortunately. The key factor to also consider is how much you can afford – both now and at the time the student goes to school. Many will also want the student to be responsible for some portion of the cost of education as well. Money put into education savings is money not available for retirement. This is a balance too many do not take into account. Please remember that any advice in this article is general in nature. How it applies to an individual situation may vary and you should consider your particular circumstances and consult your tax advisor. Hopefully this information helps sort out some of the issues on these plans. Some additional resources:
Is a 529 plan the right solution for me? - http://www.ohioscpa.com/Content/42738.aspx
Independent 529 plan - http://www.independent529plan.org/ - a private school plan with participants from around the country
College savings plan comparison - http://www.fool.com/college/compare.htm
How 529 plans work - http://money.howstuffworks.com/personal-finance/college-planning/financial-aid/529.htm
Savings bonds - http://www.finaid.org/savings/bonds.phtml
Philip Laube is a CPA in Ohio and the current Asst Vice President for Business and Finance for Muskingum University. He has a Masters in Information Strategy, Systems and Technology and publishes information on personal finance, technology and other issues both on Muskingum’s website at via twitter as phillaube.