Saving for College

Investing for Major Financial Goals

Go out into your yard and dig a big hole. Every month, throw $50 into it, but don’t take any money out until you’re ready to buy a house, send your child to college, or retire. It sounds a little crazy, doesn’t it? But that’s what investing without setting clear-cut goals is like. If you’re lucky, you may end up with enough money to meet your needs, but you have no way to know for sure.

How do you set goals?

The first step in investing is defining your dreams for the future. If you are married or in a long-term relationship, spend some time together discussing your joint and individual goals. It’s best to be as specific as possible. For instance, you may know you want to retire, but when? If you want to send your child to college, does that mean an Ivy League school or the community college down the street?

You’ll end up with a list of goals. Some of these goals will be long term (you have more than 15 years to plan), some will be short term (5 years or less to plan), and some will be intermediate (between 5 and 15 years to plan). You can then decide how much money you’ll need to accumulate and which investments can best help you meet your goals. Remember that there can be no guarantee that any investment strategy will be successful and that all investing involves risk, including the possible loss of principal.

Looking forward to retirement

After a hard day at the office, do you ask, “Is it time to retire yet?” Retirement may seem a long way off, but it’s never too early to start planning — especially if you want your retirement to be a secure one. The sooner you start, the more ability you have to let time do some of the work of making your money grow.

Let’s say that your goal is to retire at age 65 with $500,000 in your retirement fund. At age 25 you decide to begin contributing $250 per month to your company’s 401(k) plan. If your investment earns 6 percent per year, compounded monthly, you would have more than $500,000 in your 401(k) account when you retire. (This is a hypothetical example, of course, and does not represent the results of any specific investment.)

But what would happen if you left things to chance instead? Let’s say you wait until you’re 35 to begin investing. Assuming you contributed the same amount to your 401(k) and the rate of return on your investment dollars was the same, you would end up with only about half the amount in the first example. Though it’s never too late to start working toward your goals, as you can see, early decisions can have enormous consequences later on.

Some other points to keep in mind as you’re planning your retirement saving and investing strategy:

• Plan for a long life. Average life expectancies in this country have been increasing for years and many people live even longer than those averages.
• Think about how much time you have until retirement, then invest accordingly. For instance, if retirement is a long way off and you can handle some risk, you might choose to put a larger percentage of your money in stock (equity) investments that, though more volatile, offer a higher potential for long-term return than do more conservative investments. Conversely, if you’re nearing retirement, a greater portion of your nest egg might be devoted to investments focused on income and preservation of your capital.
• Consider how inflation will affect your retirement savings. When determining how much you’ll need to save for retirement, don’t forget that the higher the cost of living, the lower your real rate of return on your investment dollars.

Facing the truth about college savings

Whether you’re saving for a child’s education or planning to return to school yourself, paying tuition costs definitely requires forethought — and the sooner the better. With college costs typically rising faster than the rate of inflation, getting an early start and understanding how to use tax advantages and investment strategy to make the most of your savings can make an enormous difference in reducing or eliminating any post-graduation debt burden. The more time you have before you need the money, the more you’re able to take advantage of compounding to build a substantial college fund. With a longer investment time frame and a tolerance for some risk, you might also be willing to put some of your money into investments that offer the potential for growth.

Consider these tips as well:

• Estimate how much it will cost to send your child to college and plan accordingly. Estimates of the average future cost of tuition at two-year and four-year public and private colleges and universities are widely available.
• Research financial aid packages that can help offset part of the cost of college. Although there’s no guarantee your child will receive financial aid, at least you’ll know what kind of help is available should you need it.
• Look into state-sponsored tuition plans that put your money into investments tailored to your financial needs and time frame. For instance, most of your dollars may be allocated to growth investments initially; later, as your child approaches college, more conservative investments can help conserve principal.
• Think about how you might resolve conflicts between goals. For instance, if you need to save for your child’s education and your own retirement at the same time, how will you do it?

Investing for something big

At some point, you’ll probably want to buy a home, a car, maybe even that yacht that you’ve always wanted. Although they’re hardly impulse items, large purchases often have a shorter time frame than other financial goals; one to five years is common.

Because you don’t have much time to invest, you’ll have to budget your investment dollars wisely. Rather than choosing growth investments, you may want to put your money into less volatile, highly liquid investments that have some potential for growth, but that offer you quick and easy access to your money should you need it.

Saving for Retirement and a Child’s Education at the Same Time

You want to retire comfortably when the time comes. You also want to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child’s education at the same time can be a challenge. But take heart — you may be able to reach both goals if you make some smart choices now.

Know what your financial needs are

The first step is to determine your financial needs for each goal. Answering the following questions can help you get started:

For retirement:

• How many years until you retire?
• Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what’s your balance? Can you estimate what your balance will be when you retire?
• How much do you expect to receive in Social Security benefits? (One way to get an estimate of your future Social Security benefits is to use the benefit calculators available on the Social Security Administration’s website, www.ssa.gov. You can also sign up for a my Social Security account so that you can view your online Social Security Statement. Your statement contains a detailed record of your earnings, as well as estimates of retirement, survivor’s, and disability benefits.)
• What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?
• Do you or your spouse expect to work part-time in retirement?

For college:

• How many years until your child starts college?
• Will your child attend a public or private college? What’s the expected cost?
• Do you have more than one child whom you’ll be saving for?
• Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?
• Do you expect your child to qualify for financial aid?

Many on-line calculators are available to help you predict your retirement income needs and your child’s college funding needs.

Figure out what you can afford to put aside each month

After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you’ll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you’ve come up with a dollar amount, you’ll need to decide how to divvy up your funds.

Retirement takes priority

Though college is certainly an important goal, you should probably focus on your retirement if you have limited funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you’ll miss out on years of potential tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there’s no such thing as a retirement loan!

If possible, save for your retirement and your child’s college at the same time

Ideally, you’ll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child’s college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8% annually, you’d have $18,415 in your child’s college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment. Investment returns will fluctuate and cannot be guaranteed.)

If you’re unsure about how to allocate your funds between retirement and college, a professional financial planner may be able to help. This person can also help you select appropriate investments for each goal. Remember, just because you’re pursuing both goals at the same time doesn’t necessarily mean that the same investments will be suitable. It may be appropriate totreat each goalindependently.

Help! I can’t meet both goals

If the numbers say that you can’t afford to educate your child or retire with the lifestyle you expected, you’ll probably have to make some sacrifices. Here are some suggestions:

• Defer retirement: The longer you work, the more money you’ll earn and the later you’ll need to dip into your retirement savings.
• Work part-time during retirement.
• Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.
• Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.
• Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss). Note that no investment strategy can guarantee success.
• Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.
• Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don’t feel guilty — a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.
• Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.

Can retirement accounts be used to save for college?

Yes. Should they be? That depends on your family’s circumstances. Most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child’s college education if doing so will leave you with no funds in your retirement years. However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you’re under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you’ll generally pay a 10% penalty on any withdrawals made before you reach age 59½ (age 55 or 50 in some cases), even if the money is used for college expenses. You may also be subject to a six-month suspension from plan participationif you make a hardship withdrawal in 2017. There may be income tax consequences, as well. (Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.)

Sticker Shock: Creative Ways to Lower the Cost of College

Even with all of your savvy college shopping and research about financial aid, college costs may still be prohibitive. At these prices, you expect you’ll need to make substantial financial sacrifices to send your child to college. Or maybe your child won’t be able to attend the college of his or her choice at all. Before you throw in the towel, though, you and your child should consider steps that can actually lower college costs. Although some of these ideas deviate from the typical four-year college experience, they just might be your child’s ticket to college — and your ticket to financial sanity.

Ask about tuition discounts and flexible repayment programs

Before you rule out a college completely, ask whether it offers any tuition discounts or flexible repayment programs. For example, the school may offer a discount if you pay the entire semester’s bill up front, or if you allow the money to be directly debited from your bank account. The college may also allow you to spread your payments over 12 months or extend them for a period after your child graduates. And if it’s your alma mater, don’t forget to inquire about any discounts for the children of alumni. Finally, ask if some charges are optional (e.g., full meal plan versus limited meal plan).

Graduate in three years instead of four

Some colleges offer accelerated programs that allow your child to graduate in three years instead of four. This can save you a whole year’s worth of tuition and related expenses. Some colleges offer a similar program that combines an undergraduate/graduate degree in five years. The main drawback is that your child will have to take a heavier course load each semester and may have to forgo summer breaks to meet his or her academic obligations. Also, some educators believe that students need four years of college to develop to their fullest potential — intellectually, emotionally, and occupationally.

Earn college credit in high school

By taking advanced placement courses or special academic exams, your child may be able to earn college credits while still in high school. This means that your child may be able to take fewer classes in college, saving you money.

Think about cooperative education

Cooperative (co-op) education is a type of education where semesters of course work alternate with semesters of paid work at internships that your child helps select. Although a co-op degree usually takes five years to obtain, your child will be earning money during these years that can be used for tuition costs. In addition, your child gains valuable job experience.

Enroll in a community college, then transfer to a four-year college

One surefire way to cut college costs is to have your child enroll in a local community college for a couple of years, where costs are often substantially less than four-year institutions. Then, after two years, your child can transfer to a four-year institution. Your child’s diploma will be from the four-year institution, but your expenses won’t. Before choosing this route, though, make sure that any credits your child earns at the community college will be transferable to another institution.

Defer enrollment for a year

Your child might be aching to get to college, but taking a year off, commonly referred to as a “gap year,” can give you both some financial breathing room and allow your child to work and save money for a full year before starting college. Your child will apply under the college’s normal application deadline with the rest of his or her classmates and, once accepted, can ask for a one-year deferment. But make sure the college offers deferred enrollment before your child goes through the time and expense of applying.

Live at home

It’s not every child’s dream, but attending a nearby college and living at home, even for a year or two, can substantially reduce costs by eliminating room-and-board expenses (though your child will incur commuting costs). This arrangement may work out best at a college that has a student commuter population, because the college is likely to try to meet these students’ needs. If your child does live at home, you’ll both need to sit down beforehand and discuss mutual expectations. For example, now that your child’s in college, it’s not realistic to expect him or her to adhere to a rigid weekend curfew.

Research online learning options

Taking courses online is a trend that’s here to stay, and many colleges are in the process of creating or expanding their opportunities for online learning. Your child might be able to take a year’s worth of classes from home and then attend the same school in person for the remaining years.

Work part-time throughout the college years

Part-time work during college can help your child defray some costs, though working during school can be both a physical and emotional strain. To make sure that your child’s academic work doesn’t suffer, one option might be for your child to focus on school the first year and then obtain a part-time job in the remaining years. In addition, encouraging your child to become an RA (resident assistant) at college could earn them free room and board.

Join the military

There are several options here. Under the Reserve Officers’ Training Corps (ROTC) scholarship program, your child can receive a free college education in exchange for a required period of active duty following graduation. Your child can apply for an ROTC scholarship at a military recruiting office during his or her junior or senior year of high school. Or, your child can serve in the military and then attend college under the GI Bill. Your child can also attend a service academy, like the U.S. Military Academy at West Point, for free. Be aware, though, that these schools are among the most competitive in the country, and your child must serve a minimum number of years of active duty upon graduation. For more information, visit your local military recruiting office, or speak to your child’s high school guidance counselor.

Go to school abroad

Foreign schools generally offer an excellent education at a price comparable to that of an average four-year public college in the United States. And in the global economy, many employers tend to look favorably on studying abroad. Your child will even be eligible for need-based federal student loans (but not grants), as well as the two federal education tax credits — the American Opportunity credit and the Lifetime Learning credit.

Look for employer educational assistance

Does your employer offer any educational benefits for the children of its employees, like partial tuition reimbursement or company scholarships? Check with your human resources manager.

Have grandparents pay tuition directly to the college

Payments that grandparents (or others) make directly to a college aren’t considered gifts for purposes of the federal gift tax rules. So, grandparents can be as generous as they want without having to worry about the tax implications for themselves. Keep in mind, though, that any payments must go directly to the college. They can’t be delivered to your child with instructions to apply them to the college bills.

ABCs of Financial Aid

It’s hard to talk about college without mentioning financial aid. Yet this pairing isn’t a marriage of love, but one of necessity. In many cases, financial aid may be the deciding factor in whether your child attends the college of his or her choice. That’s why it’s important to develop a basic understanding of financial aid before your child applies to college. Without such knowledge, you may have trouble understanding the process of aid determination, filling out the proper aid applications, and comparing the financial aid awards that your child may receive.

But let’s face it. Financial aid information is probably not on anyone’s top ten list of bedtime reading material. It can be an intimidating and confusing topic. There are different types, different sources, and different formulas for evaluating your child’s eligibility. Here are some of the basics to help you get started.

What is financial aid?

Financial aid is money distributed primarily by the federal government and colleges in the form of loans, grants, scholarships, or work-study jobs. A student can receive both federal and college aid. An ideal financial aid package will contain more grants and scholarships (which don’t need to be repaid) and fewer loans.

Financial aid can be further broken down into two categories: need-based aid, which is based on a student’s financial need, and merit aid, which is based on a student’s academic, athletic, musical, or artistic talent. Both the federal government and colleges provide need-based aid in the form of loans and grants. For merit aid, colleges are the main source, and they often use favorable merit aid packages to attract the best and brightest students to their campuses.

It’s worth noting that colleges can vary significantly in their generosity when it comes to merit aid; merit awards are typically related to the size of a college’s endowment and its unique objectives. College guidebooks and marketing materials generally provide statistics on the size of a college’s average aid award (both in dollar amounts and as a percentage of the typical aid package) and the family income thresholds necessary for different aid amounts. If you’re a family researching college choices, you can help your bottom line by targeting colleges that offer significant merit aid packages. For example, some colleges have made it a policy to replace loans with grants in their financial aid packages.

In addition to colleges, many businesses, foundations, and associations offer smaller merit scholarships with specific eligibility criteria and deadlines. Various scholarship websites allow your child to input his or her background, abilities, and interests and receive (free of charge) a matching list of potential scholarships.

How is my child’s financial need determined?

Financial need is generally determined by looking at a family’s income, assets, and household information. The federal government uses the FAFSA, which stands for Free Application for Federal Student Aid; colleges generally use the PROFILE form, or their own institutional form. The FAFSA uses a formula known as the federal methodology; the PROFILE uses a formula known as the institutional methodology. The general process of aid assessment is called needs analysis.

Under the FAFSA, your current income and assets and your child’s current income and assets are run through a formula. You are allowed certain deductions and allowances against your income, and you’re able to exclude certain assets from consideration. The result is a figure known as the expected family contribution, or EFC. It’s the amount of money that you’ll be expected to contribute to college costs before you are eligible for aid.

A detailed analysis of the formula is beyond the scope of this article, but generally here’s how it works: (1) parent income is counted up to 47% (income equals adjusted gross income or AGI plus untaxed income/benefits minus certain deductions); (2) student income is counted at 50% over a certain amount ($6,570 for the 2018/2019 school year); (3) parent assets are counted at 5.6% (home equity, retirement assets, cash value life insurance, and annuities are excluded); and (4) student assets are counted at 20%.

Your EFC remains constant, no matter which college your child applies to. An important point: Your EFC is not the same as your child’s financial need. To calculate your child’s financial need, subtract your EFC from the cost of attendance at your child’s college. Because colleges aren’t all the same price, your child’s financial need will fluctuate with the cost of a particular college.

For example, you fill out the FAFSA, and your EFC is calculated to be $25,000. Assuming that the cost of attendance at College A is $65,000 per year and the cost at College B is $35,000, your child’s financial need is $40,000 at College A and $10,000 at College B.

The PROFILE application basically works the same way. However, the PROFILE generally takes a more thorough look at your income and assets to determine what you can really afford to pay (for example, the PROFILE looks at your home equity and money you may have contributed to medical and dependent care flexible spending accounts).

What factors count the most in needs analysis? Your current income is the most important factor, but other criteria play a role, such as your total assets, the number of children you’ll have in college at the same time, and how close you are to retirement age.

Estimating aid eligibility ahead of time

Getting a ballpark estimate of financial aid ahead of time can be very helpful for planning purposes. There are two ways you can do this.

First, the federal government offers an online tool called the “FAFSA4caster” that you can complete to get an estimate of your EFC. Second, every college offers a tool called a “net price calculator” on its website that you can complete to get an estimate of how much financial aid your child might be eligible for at that particular college based on your family’s financial and personal profile.

Submitting financial aid applications

The best way to complete the FAFSA is to fill it out and submit it online (it can also be completed manually and mailed to the address listed on the form). The online route is more efficient because mistakes are flagged immediately and electronic FAFSAs take only one week to process (compared to two to four weeks for paper FAFSAs). In order to complete the FAFSA online, you and your child will first need to obtain an FSA ID, which you can also do online.

The FAFSA relies on income tax information from two years prior (for example, the 2018/19 FAFSA relies on your 2016 tax return) and current asset information. The FAFSA has the ability to directly import your tax information using the IRS Retrieval Tool, which is built into the form, though you will also need to answer additional questions. The FAFSA can be filed as early as October 1st in the year prior to the year your child will be attending school.

The PROFILE (or individual college application) is usually submitted in late fall or winter but is typically required earlier if your child is applying to college early decision or early action. The specific deadline is left up to the individual college, so make sure to keep track of all college deadlines. In addition to the form itself, the CSS Profile will typically require you to submit tax returns, and possibly other financial documents, at a later date. If so, you’ll receive instructions on how to do this.

After your FAFSA is processed, your child will receive a Student Aid Report highlighting your EFC; the colleges that you list on the FAFSA will also get a copy of the report. When your child is accepted at a college, the college’s financial aid administrator will attempt to craft an aid package to help meet your child’s financial need. This is done using a combination of the following (typically in this order):

• Federal Pell Grant (for students with exceptional financial need)
• Federal Direct Stafford Loan (subsidized for students with financial need)
• Federal Direct Stafford Loan (unsubsidized for all other students)
• Federal Perkins Loan, Supplemental Educational Opportunity Grant (SEOG), and work-study (funds for these programs are allocated to colleges by the federal government for distribution to students; whether a student receives any of these funds depends on timing of application, financial need, and availability of funds)
• College grant, scholarship, or tuition discount (at the college’s discretion)

Keep in mind that colleges aren’t obligated to meet all of your child’s financial need. In fact, it’s not uncommon for colleges to meet only a portion of a student’s need, a phenomenon known as getting “gapped.” If this happens to you, you’ll have to make up the shortfall, in addition to paying your EFC. On the flip side, if a college says it is meeting “100% of your demonstrated need” keep in mind that the college is the one who determines your need, not you, and that you’ll still have to pay your EFC.

Comparing aid awards

In late winter or early spring, your child will receive financial aid award letters that detail the specific amount and type of financial aid that each college is offering. When comparing aid awards, read each award letter carefully and make sure you understand exactly what the college is offering. The goal is to compare your out-of-pocket cost at each college. To do this, look at the total cost of attendance for each college and subtract any grant or scholarship aid the college is offering. If the grant or scholarship is merit-based, find out if it’s guaranteed for each year your child is in college and what requirements must be met in order to qualify for it annually. If the grant or scholarship is need-based, find out whether you can expect a similar amount each year as long as your income and assets stay roughly the same (and you have the same number of children in college), and ask the aid office whether it increases to keep up with annual increases in tuition, fees, and room and board.

The difference between the total cost and any grant or scholarship aid is your out-of-pocket cost or “net price.” Compare this figure across all colleges. Once you determine your out-of-pocket cost at each college, determine how much, if anything, you or your child will need to borrow. Then multiply this figure by four to get an idea of what your total borrowing costs might be. Armed with this information, you’ll be in a position to make the best financial decision for your family.

If you’d like to lobby a particular school for more aid, tread carefully. A polite letter to the financial aid administrator followed up by a telephone call is appropriate. Your chances of getting more aid are best if you can document a change in circumstances that affects your ability to pay, such as a recent job loss, unusually high medical bills, or some other event that impacts your finances. Your chances of getting more aid by asking one college if they’ll match a favorable aid offer from another college is a less reliable strategy, but may be worth a shot if the colleges are direct competitors.

How much should our family rely on financial aid?

With all this talk of financial aid, it’s easy to assume that it will do most of the heavy lifting when it comes time to pay the college bills. But the reality is you shouldn’t rely too heavily on financial aid. Although aid can certainly help cover your child’s college costs, student loans often make up the largest percentage of the typical aid package, not grants and scholarships. Remember, parents and students who rely mainly on loans to finance college can end up with a considerable debt burden that can have negative financial implications for years after graduation.

The ABCs of 529 Plans

529 plans are tax-advantaged education savings vehicles and one of the most popular ways to save for education today. Much like the way 401(k) plans revolutionized the world of retirement savings a few decades ago, 529 plans have changed the world of education savings.

An overview of 529 plans

Congress created 529 plans in 1996 in a piece of legislation that had little to do with college — the Small Business Job Protection Act. Known officially as qualified tuition programs, or QTPs, under federal law, 529 plans get their more common name from section 529 of the Internal Revenue Code, which governs their existence.

Over the years, 529 plans have been modified by various pieces of legislation. The most recent change was in 2017 in the Tax Cuts and Jobs Act, which expanded the definition of a 529 plan “qualified education expense” to include K-12 tuition, up to $10,000 per year.

529 plans are governed by federal law but run by states through designated financial institutions who manage and administer specific plans. There are actually two types of 529 plans — savings plans and prepaid tuition plans. The tax advantages of each are the same, but the account features are very different. 529 savings plans are far more common.

529 savings plans

A 529 savings plan is an individual investment account, similar to a 401(k) plan, where you contribute money for college or K-12 tuition. To open an account, you fill out an application, where you choose a beneficiary and select one or more of the plan’s investment options. Then you simply decide when, and how much, to contribute.

529 savings plans offer a unique combination of features that no other education savings vehicle can match:

• Federal tax advantages: Contributions to a 529 account accumulate tax deferred and earnings are tax free if the money is used to pay the beneficiary’s qualified education expenses. (The earnings portion of any withdrawal not used for qualified education expenses is taxed at the recipient’s rate and subject to a 10% penalty.) This is the same tax treatment as Coverdell education savings accounts (ESAs).
• State tax advantages: States are free to offer their own tax benefits to state residents. For example, some states exempt qualified withdrawals from income tax or offer a tax deduction for your contributions. A few states even provide matching scholarships or matching contributions. (Note: 529 account owners who are interested in making K-12 contributions or withdrawals should understand their state’s rules regarding how K-12 funds will be treated for tax purposes as not all states may follow the federal tax treatment.)
• High contribution limits: Most plans have lifetime contribution limits of $350,000 and up (limits vary by state).
• Unlimited participation: Anyone can open a 529 savings plan account, regardless of income level. And you don’t need to be a parent to open an account. By contrast, your income must be below a certain level if you want to contribute to a Coverdell ESA.
• Simplicity: It’s relatively easy to open a 529 account, and most plans offer automatic payroll deduction or electronic funds transfer from your bank account to make saving even easier.
• Wide use of funds: Money in a 529 savings plan can be used to pay the full cost (tuition, fees, room and board, books) at any college or graduate school in the United States or abroad that is accredited by the Department of Education, and for K-12 tuition expenses up to $10,000 per year.
• Professional money management: 529 savings plans are managed by designated financial companies who are responsible for managing the plan’s underlying investment portfolios. Plans typically offer static portfolios that vary in their amount of risk and where the asset allocation in each portfolio remains the same over time, and age-based portfolios, where the underlying investments gradually and automatically become more conservative as the beneficiary gets closer to college.
• Plan variety: You’re not limited to the 529 savings plan offered by your own state. You can shop around for the plan with the best money manager, performance record, investment options, fees, and customer service.
• Beneficiary changes and rollovers: Under federal rules, you are entitled to change the beneficiary of your account to a qualified family member at any time as well as roll over (transfer) the money in your account to a different 529 plan (savings plan or prepaid tuition plan) once per calendar year without income tax or penalty implications. This lets you leave a plan that’s performing poorly and join a plan with a better track record or more investment options.
• Accelerated gifting: 529 savings plans offer an estate planning advantage in the form of accelerated gifting. This can be a favorable way for grandparents to contribute to their grandchildren’s education while paring down their own estate, or a way for parents to contribute a large lump sum. Under special rules unique to 529 plans, a lump-sum gift of up to five times the annual gift tax exclusion amount ($15,000 in 2018) is allowed in a single year, which means that individuals can make a lump-sum gift of up to $75,000 and married couples can gift up to $150,000. No gift tax will be owed, provided the gift is treated as having been made in equal installments over a five-year period and no other gifts are made to that beneficiary during the five years.
• Transfer to ABLE account: 529 account owners can roll over (transfer) funds from a 529 account to an ABLE account without federal tax consequences if certain requirements are met. An ABLE account is a tax-advantaged account that can be used to save for disability-related expenses for individuals who become blind or disabled before age 26.

529 prepaid tuition plans

A 529 prepaid tuition plan lets you save money for college, too. But it works quite differently than a 529 savings plan. Prepaid tuition plans are generally sponsored by states on behalf of in-state public colleges and, less commonly, by private colleges. For state-sponsored prepaid tuition plans, you are limited to the plan offered by your state. Only a handful of states offer prepaid tuition plans.

A prepaid tuition plan lets you prepay tuition expenses now at participating colleges, typically in-state public colleges, for use in the future. The plan’s money manager pools your contributions with those from other investors into one general fund. The fund assets are then invested to meet the plan’s future obligations. Some plans may guarantee you a minimum rate of return; others may not. At a minimum, the plan hopes to earn an annual return at least equal to the annual rate of college inflation for the most expensive college in the plan.

The most common type of prepaid tuition plan is a contract plan. With a contract plan, in exchange for your up-front cash payment (or series of payments), the plan promises to cover a predetermined amount of future tuition costs at a particular college in the plan. For example, if your up-front cash payment buys you three years’ worth of tuition at College ABC today, the plan might promise to cover two and a half years of tuition in the future. Plans have different criteria for determining how much they’ll pay out in the future. And if your beneficiary attends a school that isn’t in the prepaid plan, you’ll typically receive a lesser amount according to a predetermined formula.

The other type of prepaid tuition plan is a unit plan. With a unit plan, you purchase units or credits that represent a percentage (typically 1%) of the average yearly tuition costs at the plan’s participating colleges. Instead of having a predetermined value, these units or credits fluctuate in value each year according to the average tuition increases for that year. You then redeem your units or credits in the future to pay tuition costs; many plans also let you use them for room and board, books, and other supplies.

Note: It’s important to understand what will happen if your prepaid plan’s investment returns don’t keep pace with tuition increases at the colleges participating in the plan. Will your tuition guarantee be in jeopardy? Will your future purchases be limited or more expensive?

What are the drawbacks of 529 plans?

Here are some drawbacks of 529 plans:

• Investment guarantees: 529 savings plans don’t guarantee your investment return. You can lose some or all of the money you have contributed. And even though 529 prepaid tuition plans typically guarantee your investment return, plans may announce modifications to the benefits they’ll pay out due to projected actuarial deficits.
• Investment flexibility: With a 529 savings plan, while you can choose among a variety of investment portfolios offered by the plan, you can’t direct the portfolio’s underlying investments. And if you’re unhappy with the investment performance of the portfolios you’ve chosen, you can only change the investment portfolios on your existing contributions twice per calendar year or upon a change in the beneficiary. (However, you can also do a “same beneficiary” rollover to another 529 plan once per calendar year without penalty, which gives you another opportunity to change plans and investment options.) With a 529 prepaid tuition plan, you don’t pick any investments — the plan’s money manager is responsible for investing your contributions.
• Nonqualified withdrawals: If you use the money in your 529 plan for something other than a qualified education expense, it’ll cost you. With a 529 savings plan, you’ll pay a 10% federal penalty on the earnings portion of any nonqualified withdrawal and you’ll owe income taxes on the earnings, too (state income tax and a penalty may also apply). With a 529 prepaid plan, you must either cancel your contract to get a refund or take whatever predetermined amount the plan will give you (some plans may make you forfeit your earnings entirely; others may give you a nominal amount of interest).
• Fees and expenses: There are typically fees and expenses associated with 529 plans. Savings plans may charge an annual maintenance fee, administrative fees, and an investment fee based on a percentage of your account’s total value. Prepaid tuition plans may charge an enrollment fee and various administrative fees.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Choosing a 529 Savings Plan

With so many 529 savings plans to choose from, it’s important to ask a lot of questions in order to select the best plan for you.

Compare the plans offered by different states

If you’re interested in opening a 529 savings plan account, consider all your options. You can typically join any state’s 529 savings plan, so consider comparing a few different plans in terms of account ownership and beneficiary designation rules, tax benefits, investment options, contribution rules, and costs and fees. Any state that offers a 529 savings plan can provide you with a free packet of information that describes the program and its rules. You can also check out a plan’s website.

Account ownership and beneficiary designation rules

When comparing savings plans, keep plan flexibility in mind with respect to account ownership and beneficiary designation rules. These rules may vary from state to state. As an account owner, you’ll want to make sure the account works the way you want it to work.

Generally, the account owner retains ownership and a certain amount of control over the savings plan account. For example, he or she can change the beneficiary of the account or terminate the account and receive a refund of contributions. However, keep in mind that if you terminate the account, you’ll typically receive back only a portion of your earnings, if any, and a penalty will generally apply, unless you terminate the account because the beneficiary has died or is disabled. Here are some questions to ask when researching various plans:

• Can I own the account jointly with my spouse or another person?
• Can a trust or other entity be an account owner?
• Can I name a successor owner when I open the account? If not, what happens to the account when I die?
• Must the account owner be a state resident? Must the beneficiary be a state resident?
• What happens if the account owner or beneficiary later moves out of state?
• Are account statements issued only to the account owner or also to the beneficiary?
• If I terminate the account, how much of my contributions and earnings will I get back, and will I pay a penalty?

Tax considerations

Some individuals favor 529 savings plans over other college savings vehicles because of the federal (and sometimes state) tax advantages associated with 529 plans. Let’s face it — we all want to keep our taxes to a minimum. No matter which 529 savings plan you join, all qualified withdrawals will be free of federal income tax. But things differ at the state level.

States typically exempt the earnings in a 529 savings plan from income tax if the withdrawal used to pay qualified education expenses. Some states may also offer an income tax deduction for some or all of your plan contributions in a given year. Other states offer no such income tax benefits. Since state tax benefits can vary, and remember — you’re entitled only to the state tax benefits (if any) offered by the state in which you reside. So research the state tax benefits available in your state. Keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan only.

Consider, also, any state gift tax issues regarding contributions, and whether there are state penalties for withdrawals that are not used for permitted education expenses (most states follow the federal tax treatment for nonqualified withdrawals.)

The following questions can help you determine what tax advantages each state offers:

• Can I claim a deduction on my state income tax return for my contributions to the 529 savings plan? Is there a limitation or cap placed on the amount of my state income tax deduction? If so, what is it?
• Is my deduction recaptured into income if later withdrawals are not used for qualified education purposes?
• If a withdrawal from the savings plan is used to pay qualified education expenses, are the plan’s earnings exempt from state income tax? Must I join my own state’s 529 saving plan to get state tax benefits?
• Are K-12 contributions or withdrawals treated differently than college contributions or withdrawals for state tax purposes?

Investment options

Another consideration in choosing a 529 savings plan account is the number and type of investment options offered by each plan. Since some investors are more comfortable with risk than others, investment choice is important. For example, if you’re a conservative investor with very limited funds, you might want to choose a plan that offers one or more conservative investment options. Investment choice may also be important if you’re a sophisticated investor who wants to maximize return. However, keep in mind that all investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful.

529 savings plans typically offer several different investment portfolios that you can pick from to invest your contributions. Plans typically offer static portfolios that vary in their amount of risk and where the asset allocation in each portfolio remains the same over time, and age-based portfolios, where the underlying investments gradually and automatically become more conservative as the beneficiary gets closer to college.

If you want to change your investment option(s), you can generally do so twice per calendar year for your existing contributions, anytime for your future contributions, or anytime you change the beneficiary of the account.

You may want to look at the past investment performance of a particular portfolio and compare it with other portfolios in different plans. You should also think about the reputation of the plan manager. Here are some investment-related questions to ask:

• How many investment options does the 529 savings plan provide?
• Are age-based portfolios offered? If so, can I select a portfolio other than one designed to match the age of my designated beneficiary?
• Is there a limit on how many investment options I can choose?
• Can I choose one investment portfolio with today’s contribution, and a different portfolio with future contributions?
• Under what circumstances will the plan let me switch my existing contributions (and earnings) from one portfolio to another portfolio?
• Can I make changes to my investment selections online or over the phone, or do I need to send in a written request? Is the plan’s website easy to use?
• Who manages the plan’s investments, and how solid is that company’s reputation?
• When does the investment manager’s contract with the plan end? What happens to my account if the state changes investment managers?

Contribution rules

What’s are the plan’s contribution rules? Most plans have lifetime contribution limits of $350,000 and up. Find out the answers to the following questions:

• What’s the maximum contribution limit for the plan?
• What’s the minimum amount I must contribute to establish the savings plan?
• Are annual contributions required? If so, how much?
• Can someone other than the account owner make plan contributions? If so, what are the mechanics?
• Are the contribution limits different if I am a resident of the state or a nonresident?

Costs and fees

Since plan costs and fees can really add up and take a bite out of your funds, consider the expenses associated with each plan and compare the overall costs of different plans. Consider the following questions:

• Are residents and nonresidents treated differently in terms of plan costs and fees?
• Is there an application fee, beneficiary substitution fee, or account owner substitution fee?
• What other fees and costs are charged, and what are the amounts?
• Will my fees be less if I contribute through payroll deduction or automatic deduction from my checking account?
• Is there a fee to do a rollover to another state’s plan?
• Will I be penalized if I move my account out of the plan within a short time after I open the account? How short a time?
• Is there a fee if I terminate the account?
• Do I pay the fees separately, or is the fee deducted from my account?

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

529 Savings Plans vs. Prepaid Tuition Plans

Section 529 plans are popular education savings vehicles. To choose the type of 529 plan that’s right for you, it’s important to understand how 529 savings plans and 529 prepaid tuition plans work and the differences between them.

Who can offer each type of plan?

At one time, only states could offer 529 savings plans and 529 prepaid tuition plans. (In practice, states designate an experienced financial institution, to manage and administer their plans). However, colleges can now offer their own prepaid tuition plans. These plans are sometimes referred to as private prepaid tuition plans, and they are less common. The remainder of this discussion refers to state-sponsored prepaid tuition plans.

How does each plan work?

As 529 plans, both savings plans and prepaid tuition plans offer the same significant federal tax advantages. Funds in each type of plan grow tax deferred, and withdrawals from either plan used for the beneficiary’s qualified education expenses are completely income tax free at the federal level. But despite these shared tax advantages, savings plans and prepaid tuition plans are different creatures.

A 529 savings plan lets you save for college or K-12 tuition within an individual investment account, similar to a 401(k) plan. Money you contribute is invested in one or more of the plan’s specific investment portfolios. Each portfolio consists of a mix of investments (typically mutual funds) that are chosen and managed exclusively by the plan’s designated money manager. You generally pick your investment portfolios at the time you open an account. Your investment return is not guaranteed.

By contrast, a prepaid tuition plan lets you prepay tuition expenses now at participating colleges, typically in-state public colleges, for use in the future. The plan’s money manager pools your contributions with those from other investors into one general fund. The fund assets are then invested to meet the plan’s future obligations. Some plans may guarantee you a minimum rate of return; others may not. At a minimum, the plan hopes to earn an annual return at least equal to the annual rate of college inflation for the most expensive college in the plan.

There are generally two types of prepaid tuition plans: contract plans and unit plans. The most common type of prepaid tuition plan is a contract plan (sometimes known as a guaranteed interest plan). With a contract plan, in exchange for your up-front cash payment (or series of payments), the plan promises to cover a predetermined amount of future tuition costs at a particular college in the plan. For example, if your up-front cash payment buys you three years’ worth of tuition at College ABC today, the plan might promise to cover two and a half years of tuition in the future. Plans have different criteria for determining how much they’ll pay out in the future. And if your beneficiary attends a school that isn’t in the prepaid plan, you’ll typically receive a lesser amount according to a predetermined formula.

With a unit plan, you purchase a certain percentage of units or credits and the plan guarantees that whatever the percentage of college costs such units cover now, the same percentage will be covered in the future. For example, assume that 100 tuition credits are required to fund one year’s worth of tuition at State University today. You purchase 100 credits today for $8,000. The result is that when your child starts college at State University in 12 years, your $8,000 will theoretically pay the entire first year of tuition, even though tuition costs may have risen to $20,000 per year by then.

Note: Even though prepaid tuition plans typically guarantee your investment return, plans sometimes announce modifications to the benefits they’ll pay out due to projected actuarial deficits. It’s important to understand what will happen if your prepaid plan’s investment returns don’t keep pace with tuition increases at the colleges participating in the plan. Will your tuition guarantee be in jeopardy? Will your future purchases be limited or more expensive?

How are contributions invested with each type of plan?

529 savings plans and 529 prepaid tuition plans differ on the way your contributions are invested. With a prepaid plan, there are no individual investment accounts. Instead, your contributions go into a general fund, and the plan’s money manager is solely responsible for investing the pooled money to meet the plan’s future obligations to its participants. Your only concern is with the predetermined amount of tuition that the plan has agreed to cover in the future, or the percentage of tuition costs that the units or credits you’ve just purchased will eventually cover.

With a savings plan, your contributions are held in an individual investment account in one or more specific investment portfolios that you’ve chosen. Typically, plans offer a variety of options from aggressive to conservative so you can choose a portfolio that matches your risk tolerance, time horizon, and other factors. Specifically, plans typically offer static portfolios that vary in their amount of risk and where the asset allocation in each portfolio remains the same over time, and age-based portfolios, where the underlying asset mix gradually and automatically becomes more conservative — for example, from stock mutual funds to bond and money market funds — as the beneficiary gets closer to college. But remember, the plan’s money manager handles the underlying investment mix in each portfolio on a day-to-day basis — you have no say in this process.

Once you’ve settled on an investment portfolio(s) for your savings plan account, you have limited opportunities to change it if you’re not happy with its investment performance. Under federal rules, plans are authorized, but not required, to let you change your investment portfolio twice per calendar year or at any time you change the beneficiary. (However, you can generally direct future contributions to a new investment portfolio at any time.) Such investment flexibility can make one plan stand out among others, so it’s always a good idea to check the specific investment rules of any plan you’re considering.

You also have another option guaranteed by federal law. You can roll over the funds in your existing saving plan account to another 529 plan (savings plan or prepaid tuition plan) once per calendar year without penalty. The beneficiary must stay the same.

In your effort to pick a suitable portfolio, keep in mind that no investment in a savings plan is guaranteed — you could lose money that you’ve contributed. That’s why it’s important to investigate the reputation and overall investment performance of the institution that manages the plan, as well as the performance history of individual portfolios in the plan.

Are there any restrictions on joining either type of plan or accessing the funds?

Yes. Most 529 savings plans are open to residents of every state. This means you can shop around for the plan that offers the combination of features you want. (But keep in mind that if you join another state’s savings plan, your state may limit any state tax benefits, if any, to the in-state 529 plan only.) Beyond that, you can open a 529 savings plan at any time of the year, and the account can generally remain open indefinitely. This gives you flexibility if your child decides to postpone his or her education.

By contrast, state-sponsored prepaid tuition plans are limited to state residents only. And once you open an account, all tuition credits generally must be used by the time your child turns 30, and all withdrawals completed within 10 years from the time your child starts college. Also, at some point before your child starts college, you (the account owner) are required to inform the plan administrator when you expect to start redeeming credits. Finally, some prepaid tuition plans let you join only during specific enrollment periods.

What education expenses are covered by each plan?

529 savings plans give you more flexibility in paying your beneficiary’s education expenses. Funds in the account can be used to pay the full cost of tuition, fees, books, equipment, and room and board (assuming the beneficiary is enrolled at least half-time) at any college in the United States or abroad that’s accredited by the Department of Education. This includes undergraduate colleges, graduate and professional schools, two-year colleges, technical and trade schools, as well as some foreign colleges and universities. Funds in a 529 savings plan can also be used to pay K-12 tuition expenses, up to $10,000 per year.

By contrast, prepaid tuition plans are typically designed to pay only for undergraduate tuition costs at in-state public colleges — other expenses like room and board, books, and graduate school may not be covered. However, such restrictions are imposed by the individual prepaid tuition plans, because Section 529 of the Internal Revenue Code allows a broader interpretation of qualified education expenses. Make sure you understand exactly what education expenses your prepaid tuition plan covers, as well as the tuition equivalent you’ll receive if your child attends a private or out-of-state college.

What are the fees and expenses with each type of plan?

529 savings plans, like other types of managed accounts such as mutual funds and annuities, are managed by professional money managers who pass along their investment expenses to account owners. In addition, the plan manager will charge a fee for administering your account. Both of these fees are usually equal to a percentage of your total account value. Some savings plans may also tack on a flat annual maintenance fee, though this may be waived if you sign up for automatic payroll deduction or direct debiting of your checking account. Because fees and expenses vary among plans and can affect your account’s total return, examine them carefully.

Prepaid tuition plans typically charge a flat enrollment fee at the time you open your account, but generally there are no ongoing charges. However, you may be assessed fees for late payment, returned checks, changing the beneficiary, changing the beneficiary’s enrollment date, document replacement, or other administrative matters.

You may want to ask the following questions to help you better compare the fees of savings plans vs. prepaid tuition plans:

• Is there an application fee, beneficiary substitution fee, or account owner substitution fee?
• What other fees and costs are charged, and what are the amounts?
• Will my fees be less if I contribute through payroll deduction or automatic deduction from my checking account?
• Is there a fee to do a rollover to another state’s plan?
• Will I be penalized if I move my account out of the plan within a short time after I open the account? How short a time?
• Is there a fee if I terminate the account?
• Do I pay the fees separately, or is the fee deducted from my account?

What is the income tax treatment of withdrawals from each plan?

Withdrawals from a savings plan or prepaid tuition plan used to pay the beneficiary’s qualified education expenses (as defined by the individual plan within federal guidelines) are completely income tax free at the federal level. States may offer their own tax benefits, but may make them contingent on joining the in-state 529 plan.

A withdrawal not used for the beneficiary’s qualified education expenses is called a nonqualified withdrawal. A nonqualified withdrawal from a savings plan or a unit type of prepaid tuition plan (where you purchase tuition credits) will result in a 10% federal penalty on the earnings portion of the withdrawal (a state penalty may also apply). What’s more, the earnings portion of the withdrawal will be subject to federal and typically state income tax, too.

A nonqualified withdrawal isn’t possible if you have a contract type of prepaid tuition plan. If you want to get your money out of this type of plan, your only choice is to cancel your contract and have your money refunded. (If you do cancel, you may only get back your actual contributions, with no interest or earnings included. Other plans will refund your principal plus a low rate of interest, which is then taxable at regular income tax rates.)

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Opening a 529 Account

You’ve decided to enroll in a 529 plan to fund your child’s education, but how do you go about doing it? Opening an account is actually quite simple as long as you understand the process. Here is an overview to help you get started.

Completing an account application

To enroll in a 529 plan, you’ll need to request an enrollment kit from the plan manager. The enrollment kit generally contains an application and a handbook that contains information on plan rules and investment options (if any). After carefully studying the materials in the enrollment kit, fill out and sign the application. You may be asked to give the following information on your 529 plan application:

• Name, address, and phone number of the account owner
• Name and address of the beneficiary
• Social Security number (or tax ID number) of the account owner and the beneficiary
• Birth date, school grade, and state of residence of beneficiary
• Relationship between the account owner and beneficiary
• Your funding schedule for the account
• Automatic payment information
• The investment option you wish to choose
• The successor owner you wish to designate (in the event of your death)

To make the application process easier, nearly every plan now has a downloadable version of its application available on the Internet. A growing number of states also allow you to complete your enrollment on-line.

Naming a beneficiary

When you open an account, you’ll need to designate someone as beneficiary. The beneficiary is the person who will receive the plan proceeds. You can generally name anyone you choose as the beneficiary — your child, grandchild, niece, nephew, or other relative or friend. (Your choice of a beneficiary may have gift tax and generation-skipping transfer tax consequences.) Some plans even allow you to name yourself. But rules vary from state to state, so read the guidelines set out in the plan handbook before you name a beneficiary.

Choosing an investment option

529 savings plans allow you to choose among several diversified investment options chosen by the plan’s professional fund manager. These options fall into two categories: age-based portfolios and static portfolios. If you choose an age-based portfolio, contributions will be placed in a portfolio of investments based on your child’s age (or in some plans, the date you intend to use the funds). When your child is young, the portfolio may allocate its investments primarily to stock funds that may entail higher risk but offer higher returns than fixed income funds and money market funds. As your child approaches college age, the allocation may gradually shift to fixed income funds and money market funds.

If you choose a static portfolio, contributions will be placed in a portfolio with a fixed allocation of investments from the various investment categories. You may be able to choose an equity fund, where 70% to 100% of the holdings are in stocks; a fixed income fund, containing 70% to 100% bond and money market instruments; or a balanced fund that includes a mixture of stock and fixed income assets. You’ll need to choose a fund based on factors like your child’s age, your tolerance for risk, and your overall financial plan. Keep in mind that all investing involves risk, including the possible loss of principal, and there can be no assurance that any investment strategy will be successful.

If you want to change your investment options at a later date, you can generally do so only twice per calendar year for your existing contributions, anytime for your future contributions, or anytime you change the beneficiary of the account.

529 prepaid tuition plans work differently. With prepaid tuition plans, you can’t choose among different portfolios. Instead, you buy tuition credits that are guaranteed to increase in value and meet their equivalent cost of tuition when your child starts college.

Making an initial contribution

When you submit your application, you’ll need to make an initial contribution. The amount required to open an account varies from state to state. Many 529 savings plans allow you to make a small initial contribution (e.g., $25 or $50) if you agree to set up automatic contributions through payroll deductions or automatic bank transfers. (A growing number of companies let their employees contribute to savings plans via payroll deduction.) Thereafter, minimum contributions of at least $15 to $25 are generally required, although a few states have much higher minimums. The amount of the minimum contribution may also be different for residents and nonresidents of the state that sponsors the plan.

With a prepaid tuition plan, you purchase a contract that covers the cost of tuition and fees for a certain number of years. Most prepaid tuition plans require that accounts be fully funded in five years. The cost of a contract varies from state to state and may depend on the beneficiary’s age at the time the contract is purchased. You can generally pay for the contract in either a lump sum or through installment payments.

Managing the account

Once you’ve opened your 529 account, make sure you periodically check how the plan is performing. Even though a professional fund manager will handle day-to-day investment decisions, you should monitor the progress of your account’s growth (although you will have limited opportunities to change your investment portfolios). Also, if you’re currently making installment payments, you might consider making a lump-sum contribution in the future. In that case, you’ll need to become aware of federal gift tax rules. And as you approach the day when you’ll begin withdrawing money from the account, you’ll want to find out how the timing of withdrawals can affect financial aid to your child.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

529 Plans: The Ins and Outs of Contributions and Withdrawals

529 plans can be powerful college savings tools, but you need to understand how your plan works before you can take full advantage of it. Among other things, this means becoming familiar with the finer points of contributions and withdrawals.

How much can you contribute?

To qualify as a 529 plan under federal rules, a state program must not accept contributions in excess of the anticipated cost of a beneficiary’s qualified education expenses. At one time, this meant five years of tuition, fees, and room and board at the costliest college under the plan, pursuant to the federal government’s “safe harbor” guideline. Now, however, states are interpreting this guideline more broadly, revising their limits to reflect the cost of attending the most expensive schools in the country and including the cost of graduate school. As a result, most states have contribution limits of $350,000 and up (and most states will raise their limits each year to keep up with rising college costs).

A state’s limit will apply to either kind of 529 plan: savings plan or prepaid tuition plan. For a prepaid tuition plan, the state’s limit is a limit on the total contributions. For example, if the state’s limit is $300,000, you can’t contribute more than $300,000. On the other hand, a savings plan limits the value of the account for a beneficiary. When the value of the account (including contributions and investment earnings) reaches the state’s limit, no more contributions will be accepted. For example, if the state’s limit is $400,000 and you contribute $325,000 and the account has $75,000 of earnings, you won’t be able to contribute any more — the total value of the account has reached the $400,000 limit.

These limits are per beneficiary, so if two people each open an account for the same beneficiary with the same plan, the combined contributions can’t exceed the plan limit. If you have accounts in more than one state, ask each plan’s administrator if contributions to other plans count against the state’s maximum. Generally, contribution limits don’t cross state lines. In other words, contributions made to one state’s 529 plan don’t count toward the lifetime contribution limit in another state. But check the rules of each state’s plan.

How little can you start off with?

Some plans have minimum contribution requirements. This could mean one or more of the following: (1) you have to make a minimum opening deposit when you open your account, (2) each of your contributions has to be at least a certain amount, or (3) you have to contribute at least a certain amount every year. But some plans may waive or lower their minimums (e.g., the opening deposit) if you set up your account for automatic payroll deductions or bank-account debits. Some will also waive fees if you set up such an arrangement. (A growing number of companies are letting their employees contribute to savings plans via payroll deduction.) Like contribution limits, minimums vary by plan, so be sure to ask your plan administrator.

Know your other contribution rules

Here are a few other basic rules that apply to most 529 plans:

• Only cash contributions are accepted (e.g., checks, money orders, credit card payments). You can’t contribute stocks, bonds, mutual funds, and the like. If you have money tied up in such assets and would like to invest that money in a 529 plan, you must liquidate the assets first.
• Contributions may be made by virtually anyone (e.g., your parents, siblings, friends). Just because you’re the account owner doesn’t mean you’re the only one who’s allowed to contribute to the account.
• 529 savings plans typically offer several different investment portfolios that you can pick from to invest your contributions. If you want to change your investment option, you can generally do so twice per calendar year for your existing contributions, anytime for your future contributions, or anytime you change the beneficiary of the account.
• 529 account owners who are interested in making K-12 contributions or withdrawals should understand their state’s rules regarding how K-12 funds will be treated for tax purposes. Some states may not follow the federal tax treatment. In addition, account owners should check with the 529 plan administrator to determine whether a K-12 withdrawal request should be made payable to the account owner, the beneficiary, or the K-12 institution.

Maximizing your contributions

Although 529 plans are tax-advantaged vehicles, there’s really no way to time your contributions to minimize federal taxes. (If your state offers a generous income tax deduction for contributing to its plan, however, consider contributing as much as possible in your high-income years.) But there may be simple strategies you can use to get the most out of your contributions.

For example, investing up to your plan’s annual limit every year may help maximize total contributions. Also, a contribution of $15,000 a year or less in 2018 qualifies for the annual federal gift tax exclusion. And under special rules unique to 529 plans, you can gift a lump sum of up to five times the annual gift tax exclusion — $75,000 for individual gifts or $150,000 for joint gifts — and avoid federal gift tax, provided you make an election on your tax return to spread the gift evenly over five years. This is a valuable strategy if you wish to remove assets from your taxable estate.

Lump-sum vs. periodic contributions

A common question is whether to fund a 529 plan gradually over time, or with a lump sum. The lump sum would seem to be better because 529 plan earnings grow tax deferred — so the sooner you put money in, the sooner you can start to potentially generate earnings. Investing a lump sum may also save you fees over the long run. But the lump sum may have unwanted gift tax consequences, and your opportunities to change your investment portfolio are limited. Gradual investing may let you easily direct future contributions to other portfolios in the plan. And realistically, many parents may not be able to fund their account with a lump sum, but they may be able to easily make monthly investments.

Qualified withdrawals are tax free

Withdrawals from a 529 plan that are used to pay qualified education expenses are completely free from federal income tax and may also be exempt from state income tax. For 529 savings plans, qualified education expenses include the full cost of tuition, fees, books, equipment, and room and board (assuming the student is attending at least half-time) at any college or graduate school in the United States or abroad that is accredited by the Department of Education, and for K-12 tuition expenses, up to $10,000 per year.

Note: A 529 plan must have a way to make sure that a withdrawal is really used for qualified education expenses. Many plans require that the college be paid directly for education expenses; others will prepay or reimburse the beneficiary for such expenses (receipts or other proof may be required).

Beware of nonqualified withdrawals

A nonqualified withdrawal is any withdrawal that’s not used for qualified education expenses. For example, if you take money from your account for medical bills or other necessary expenses, you’re making a nonqualified withdrawal. The earnings portion of any nonqualified withdrawal is subject to federal income tax and a 10% federal penalty (and may also be subject to a state penalty and income tax).

Is timing withdrawals important?

As account owner, you can decide when to withdraw funds from your 529 plan and how much to take out — and there are ways to time your withdrawals for maximum advantage. It’s important to coordinate your withdrawals with the education tax credits (American Opportunity credit and Lifetime Learning credit). That’s because the tuition expenses that are used to qualify for a credit can’t be the same tuition expenses paid with tax-free 529 funds. A tax professional can help you sort this out to ensure that you get the best overall results. It’s also a good idea to wait as long as possible to withdraw from the plan. The longer the money stays in the plan, the more time it has to grow tax deferred.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Making Changes to Your 529 Account

529 plans are designed to accommodate the account changes that you may need to make over the years. Whether you need to change the account owner or beneficiary, your investment options, or your monthly contributions, here’s what you’ll need to know.

Changing the beneficiary

If the existing beneficiary no longer needs the funds in your 529 account (e.g., he or she gets a full scholarship or decides not to go to college), you may want to designate a new beneficiary. All 529 plans allow the account owner to change the designated beneficiary, and it’s actually quite simple to do. Just fill out a change of beneficiary form and submit it to your 529 plan administrator. Depending on your plan, you may have to pay an administrative fee.

If the existing beneficiary needs only some of the funds in your 529 account, you can also do a partial change of beneficiary, which involves establishing another 529 account for a new beneficiary and rolling over some funds from the old account into the new account.

Note, though, that in order to avoid penalties and taxes when changing beneficiaries, the new beneficiary must be a family member of the old beneficiary. According to Section 529 of the Internal Revenue Code, “family members” include children and their descendants, stepchildren, siblings, parents, stepparents, nieces, nephews, aunts, uncles, in-laws, and first cousins. States are free to impose additional restrictions, such as age and residency requirements.

Another important consideration when changing 529 plan beneficiaries is the original source of the funds that were used to create the account. If a 529 plan is opened using money already owned by your minor child through an UTMA/UGMA custodial account, the plan administrator generally will not allow beneficiary changes prior to the original beneficiary’s 18th or 21st birthday (depending on the state). In addition, these “custodial 529 plans” also come with a sunset provision for account ownership or control — when the current beneficiary of a custodial 529 plan reaches the age of legal ownership, he or she will have the right to contact the 529 plan administrator and take direct ownership of the 529 account, regardless of who may be in control of the account up to that time.

Changing the account owner

Most states allow a change in ownership of a 529 account. And unlike a change in beneficiary, there is usually no requirement that the new account owner have any particular relationship with the original account owner. Many states, however, allow a change in account owner only when the original account owner dies or in special circumstances (e.g., divorce). Check with your plan administrator for more details.

Changing your investment options

One of the disadvantages of a 529 savings plan is the lack of investment control an account owner has. Participants in a 529 plan aren’t allowed to direct the underlying investment decisions of the plan and have limited flexibility to change the investment option on their existing contributions.

If you’re unhappy with your portfolio’s investment performance, you can generally make changes to your existing portfolio twice per calendar year. Also, some plans may allow you to make changes to your existing investment portfolio if you change the beneficiary of the account. By contrast, you can generally direct your investment options on your future contributions at any time. Make sure to check the rules of any plan you’re considering.

There is one other option that’s allowed by federal law and not subject to a plan’s own rules. You can shop around for the investment options you prefer by doing a “same beneficiary” rollover to another 529 plan (savings plan or prepaid tuition plan) once per calendar year without penalty.

Changing your monthly contributions

Most 529 plans allow you to make contributions by having them automatically debited from your bank account. Some plans may even offer discounts for enrolling in an automatic payment plan. If you are using this method and wish to change the amount of your contribution or the date you contribute each month, visit the plan’s website to make these routine changes, or contact the plan administrator for more details.

Switching to a new 529 plan

If you’re unhappy with your current 529 plan’s investment performance or you believe that another plan offers more advantages, you may want to switch to another 529 plan. As mentioned before, a rollover to another 529 plan (savings plan or prepaid tuition plan) without a change in beneficiary is allowed once per calendar year without penalty. However, if you want to roll over your account more than once a year, you’ll need to change the beneficiary to another qualifying family member to avoid paying a penalty. Make sure to check with your existing plan to see if there is a fee to exit the plan or change the beneficiary.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

529 Plans and Financial Aid Eligibility

If you’re thinking about opening a 529 account, or if you’ve already opened one, you might be wondering how 529 funds will affect your child’s financial aid eligibility.

A general word about financial aid

The financial aid process is all about assessing what a family can afford to pay for college and trying to fill the gap. To do this, the federal government and colleges examine a family’s income and assets to determine how much a family should be expected to contribute before receiving financial aid. Financial aid formulas weigh assets differently, depending on whether they are owned by the parent or the child. So, it’s important to know how your 529 account will be classified, because this will affect the amount of your child’s financial aid award.

Financial aid can consist of loans (which must be repaid in the future), grants or scholarships, and/or a work-study job. The typical financial aid package contains all of these types of aid. There are no guarantees that a larger financial aid award will consist of favorable grants and scholarships — your child may simply get more loans.

The two main sources of financial aid are the federal government and colleges. In determining a student’s financial need, the federal government uses a formula known as the federal methodology, while colleges use a formula known as the institutional methodology. The treatment of 529 accounts may differ, depending on the formula used.

How is financial need determined?

Though the federal government and colleges use different formulas to assess financial need, the basic process is the same. You and your child fill out a financial aid application by listing your current assets, income, and personal family information (exactly what assets must be listed will depend on the formula used). The federal application is called the FAFSA, which stands for Free Application for Federal Student Aid; colleges generally use an application known as the CSS Profile.

Your family’s asset and income information is run through a specific formula to determine your expected family contribution, or EFC. Your EFC represents the amount of money that your family is considered to have available to put toward college costs for that year. The federal government uses its EFC figure in distributing federal aid; colleges uses their own EFC figure when distributing their own institutional aid.

The difference between your EFC and the cost of attendance (COA) at your child’s college equals your child’s financial need. The COA generally includes billed costs for tuition, fees, room and board and a designated sum for non-billed costs for books, transportation, and personal expenses. It’s important to remember that the amount of your child’s financial need will vary, depending on the cost of a particular school.

The results of your FAFSA are sent to every college that your child applies to. Every college that accepts your child will then attempt to craft a financial aid package to meet your child’s financial need. In addition to the federal EFC figure, colleges that use the CSS Profile form will have that EFC figure too. Eventually, the financial aid administrator will create an aid package made up of loans, grants, scholarships, and/or a work-study job. Some of the aid will be from federal programs and the rest will be from the college’s own funds. Keep in mind that colleges aren’t obligated to meet all of your child’s financial need. If they don’t, you’re responsible for the shortfall.

The financial aid treatment of 529 plans

Now let’s see how a 529 account affects federal financial aid.

Under the federal methodology, 529 plans — both savings plans and prepaid tuition plans — are considered an asset of the parent if the parent is the account owner. In this case, the value of the account is listed as an asset on the FAFSA. Under the federal formula, a parent’s assets are assessed (counted) at a rate of no more than 5.6%. This means that every year, the federal government treats 5.6% of a parent’s assets as available to help pay college costs. (By contrast, student assets are assessed at a rate of 20%.)

There are a few points to keep in mind regarding the classification of 529 plans as a parent asset:

• A parent is required to list a 529 plan as an asset only if he or she is the account owner of the plan. If a grandparent is the account owner, then the 529 plan doesn’t need to be listed as an asset on the FAFSA (this doesn’t seem fair, but grandparent-owned 529 accounts are counted in a different way, discussed below.)
• Any student-owned or UTMA/UGMA-owned 529 account is also reported as a parent asset if the student files the FAFSA as a dependent student. A 529 account is considered an UTMA/UGMA-owned account when UTMA/UGMA assets are transferred to a 529 account on behalf of the same beneficiary.
• If your adjusted gross income is less than $50,000 and you meet a few other requirements, the federal government doesn’t count any of your assets in determining your EFC. So your 529 account wouldn’t affect your child’s financial aid eligibility at all.

Withdrawals from a parent-owned 529 account that are used to pay the beneficiary’s qualified education expenses aren’t classified as either parent or student income on the FAFSA the following year.

Now, what about grandparent-owned 529 accounts? Grandparent-owned accounts are not listed as an asset on the FAFSA. However, withdrawals from a grandparent-owned 529 account are counted as student income on the FAFSA the following year. Student income is assessed at 50%, which means that a student’s eligibility for financial aid could decrease by 50% in the year following the withdrawal. As a result, grandparents may want to wait until the spring of their grandchild’s junior year of college to make a withdrawal if they are concerned about the potential impact on financial aid.

Regarding the institutional methodology, 529 plans are generally treated the same as under the federal methodology. But check with your child’s individual college for more information.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Income Tax Planning and 529 Plans

The income tax benefits offered by 529 plans make these plans attractive to parents (and others) who are saving for college or K-12 tuition. Qualified withdrawals from a 529 plan are tax free at the federal level, and some states also offer tax breaks to their residents. It’s important to evaluate the federal and state tax consequences of plan withdrawals and contributions before you invest in a 529 plan.

Federal income tax treatment of qualified withdrawals

There are two types of 529 plans — savings plans and prepaid tuition plans. The federal income tax treatment of these plans is identical. Your contributions accumulate tax deferred, which means that you don’t pay income taxes on the earnings each year. Then, if you withdraw funds to pay the beneficiary’s qualified education expenses, the earnings portion of your withdrawal is free from federal income tax. This feature presents a significant opportunity to help you accumulate funds for college.

Qualified education expenses for 529 savings plans include the full cost of tuition, fees, room and board, books, equipment, and computers for college and graduate school, plus K-12 tuition expenses for enrollment at an elementary or secondary public, private, or religious school up to $10,000 per year.

Qualified education expenses for 529 prepaid tuition plans generally include tuition and fees for college only (not graduate school) at the colleges that participate in the plan.

State income tax treatment of qualified withdrawals

States differ in the 529 plan tax benefits they offer to their residents. For example, some states may offer no tax benefits, while others may exempt earnings on qualified withdrawals from state income tax and/or offer a deduction for contributions. However, keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan.

You should look to your own state’s laws to determine the income tax treatment of contributions and withdrawals. In general, you won’t be required to pay income taxes to another state simply because you opened a 529 account in that state. But you’ll probably be taxed in your state of residency on the earnings distributed by your 529 plan (whatever state sponsored it) if the withdrawal in not used to pay the beneficiary’s qualified educations expenses.

529 account owners who are interested in making K-12 contributions or withdrawals should understand their state’s rules regarding how K-12 funds will be treated for tax purposes. States may not follow the federal tax treatment.

Income tax treatment of nonqualified withdrawals (federal and state)

If you make a nonqualified withdrawal (i.e., one not used for qualified education expenses), the earnings portion of the distribution will usually be taxable on your federal (and probably state) income tax return in the year of the distribution. The earnings are usually taxed at the rate of the person who receives the distribution (known as the distributee). In most cases, the account owner will be the distributee. Some plans specify who the distributee is, while others may allow you (as the account owner) to determine the recipient of a nonqualified withdrawal.

You’ll also pay a federal 10% penalty on the earnings portion of the nonqualified withdrawal. There are a couple of exceptions, though. The penalty is generally waived if you terminate the 529 account because the beneficiary has died or become disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship. A state penalty may also apply.

Deducting your contributions to a 529 plan

Unfortunately, you can’t claim a federal income tax deduction for your contributions to a 529 plan. Depending on where you live, though, you may qualify for a deduction on your state income tax return. A number of states offer a state income tax deduction for contributions to a 529 plan. Again, keep in mind that most states let you claim an income tax deduction on your state tax return only if you contribute to your own state’s 529 plan.

Many states that offer a deduction for contributions impose a deduction cap, or limitation, on the amount of the deduction. For example, if you contribute $10,000 to your child’s 529 plan this year, your state might allow you to deduct only $4,000 on your state income tax return. Check the details of your 529 plan and the tax laws of your state to learn whether your state imposes a deduction cap.

Also, if you’re planning to claim a state income tax deduction for your contributions, you should learn whether your state applies income recapture rules to 529 plans. Income recapture means that deductions allowed in one year may be required to be reported as taxable income if you make a nonqualified withdrawal from the 529 plan in a later year. Again, check the laws of your state for details.

Coordination with Coverdell account and education tax credits

You can fund a Coverdell education savings account and a 529 account in the same year for the same beneficiary without triggering a penalty.

You can also claim an education tax credit (American Opportunity credit or Lifetime Learning credit) in the same year you withdraw funds from a 529 plan to pay for qualified education expenses. But your 529 plan withdrawal will not be completely tax free on your federal income tax return if it’s used to cover the same education expenses that you are using to qualify for an education credit. (When calculating the amount of your qualified education expenses for purposes of your 529 withdrawal, you’ll have to reduce your qualified expenses figure by any expenses used to compute the education tax credit.)

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Estate Planning and 529 Plans

When you contribute to a 529 plan, you’ll not only help your child, grandchild, or other loved one pay for school, but you’ll also remove money from your taxable estate. This will help you minimize your tax liability and preserve more of your estate for your loved ones after you die. So, if you’re thinking about contributing money to a 529 plan, it pays to understand the gift and estate tax rules.

Overview of gift and estate tax rules

If you give away money or property during your life, you may be subject to federal gift tax (these transfers may also be subject to tax at the state level).

Federal gift tax generally applies if you give someone more than the annual gift tax exclusion amount, currently $15,000, during the tax year. (There are several exceptions, though, including gifts you make to your spouse.) That means you can give up to $15,000 each year, to as many individuals as you like, federal gift tax free.

In addition, you’re allowed an “applicable exclusion amount” that effectively exempts around $11,200,000 in 2018 for total lifetime gifts and bequests made at death.

Note: State tax treatment may differ from federal tax treatment, so look to the laws of your state to find out how your state will treat a 529 plan gift.

Contributions to a 529 plan treated as gifts to the beneficiary

A contribution to a 529 plan is treated under the federal gift tax rules as a completed gift from the donor to the designated beneficiary of the account. Such contributions are considered present interest gifts (as opposed to future or conditional gifts) and qualify for the annual federal gift tax exclusion. In 2018, this means you can contribute up to $15,000 to the 529 account of any beneficiary without incurring federal gift tax.

So, if you contribute $18,000 to your grandchild’s 529 plan in a given year, for example, you’d ordinarily apply this contribution against your $15,000 annual gift tax exclusion. This means that although you’d theoretically need to report the entire $18,000 gift on a federal gift tax return, you’d show that only $3,000 is taxable. Bear in mind, though, that you must use up your federal applicable exclusion amount (about $11,200,000 in 2018) before you’d actually have to write a check for the gift tax.

Special rule if you contribute a lump sum

Section 529 plans offer a special gifting feature. Specifically, you can make a lump-sum contribution to a 529 plan of up to five times the annual gift tax exclusion ($75,000 in 2018), elect to spread the gift evenly over five years, and completely avoid federal gift tax, provided no other gifts are made to the same beneficiary during the five-year period. A married couple can gift up to $150,000.

For example, if you contribute $75,000 to your grandchild’s 529 account in one year and make the election, your contribution will be treated as if you’d made a $15,000 gift for each year of a five-year period. That way, your $75,000 gift would be nontaxable (assuming you don’t make any additional gifts to your grandchild in any of those five years).

If you contribute more than $75,000 ($150,000 for joint gifts) to a particular beneficiary’s 529 plan in one year, the averaging election applies only to the first $75,000 ($150,000 for joint gifts); the remainder is treated as a gift in the year the contribution is made.

What about gifts from a grandparent?

Grandparents need to keep the federal generation-skipping transfer tax (GSTT) in mind when contributing to a grandchild’s 529 account. The GSTT is a tax on transfers made during your life and at your death to someone who is more than one generation below you, such as a grandchild. The GSTT is imposed in addition to (not instead of) federal gift and estate tax. Like the basic gift tax exclusion amount, though, there is a GSTT exemption (also about $11,200,000 in 2018). No GSTT will be due until you’ve used up your GSTT exemption, and no gift tax will be due until you’ve used up your applicable exclusion amount.

If you contribute no more than $15,000 to your grandchild’s 529 account during the tax year (and have made no other gifts to your grandchild that year), there will be no federal tax consequences — your gift qualifies for the annual federal gift tax exclusion, and it is also excluded for purposes of the GSTT.

If you contribute more than $15,000, you can elect to treat your contribution as if made evenly over a five-year period (as discussed previously). Only the portion that causes a federal gift tax will also result in a GSTT.

Note: Contributions to a 529 account may affect your eligibility for Medicaid. Contact an experienced elder law attorney for more information.

What if the owner of a 529 account dies?

If the owner of a 529 account dies, the value of the 529 account will not usually be included in his or her estate. Instead, the value of the account will be included in the estate of the designated beneficiary of the 529 account.

There is an exception, though, if you made the five-year election (as described previously) and died before the five-year period ended. In this case, the portion of the contribution allocated to the years after your death would be included in your federal gross estate. For example, assume you made a $50,000 contribution to a 529 savings plan in Year 1 and elected to treat the gift as if made evenly over five years. You die in Year 2. Your Year 1 and Year 2 contributions of $10,000 each ($50,000 divided by 5 years) are not part of your federal gross estate. The remaining $30,000 would be included in your gross estate.

Some states have an estate tax like the federal estate tax; other states calculate estate taxes differently. Review the rules in your state so you know how your 529 account will be taxed at your death.

When the account owner dies, the terms of the 529 plan will control who becomes the new account owner. Some states permit the account owner to name a contingent account owner, who’d assume all rights if the original account owner dies. In other states, account ownership may pass to the designated beneficiary. Alternatively, the account may be considered part of the account owner’s probate estate and may pass according to a will (or through the state’s intestacy laws if there is no will).

What if the beneficiary of a 529 account dies?

If the designated beneficiary of your 529 account dies, look to the rules of your plan for control issues. Generally, the account owner retains control of the account. The account owner may be able to name a new beneficiary or else make a withdrawal from the account. The earnings portion of the withdrawal would be taxable, but you won’t be charged a penalty for terminating an account upon the death of the beneficiary.

Keep in mind that if the beneficiary dies with a 529 balance, the balance may be included in the beneficiary’s taxable estate.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

529 Plans vs. Coverdell Education Savings Accounts

How do 529 plans and Coverdell education savings accounts compare when saving for education costs?

Definitions

A 529 plan is a tax-advantaged savings vehicle that let you save money for the education expenses of a named beneficiary, such as a child or grandchild. There are two types of 529 plans: savings plans and prepaid tuition plans. A savings plan lets you save money for college or K-12 in an individual investment account. A prepaid tuition plan pools your contributions with those of other investors and allows you to prepay the cost of college tuition at today’s prices for use in the future.

For 529 savings plans, qualified education expenses include the full cost of tuition, fees, room and board, books, equipment, and computers for college and graduate school, plus K-12 tuition expenses for enrollment at an elementary or secondary public, private, or religious school up to $10,000 per year.

For 529 prepaid tuition plans, qualified education expenses generally include tuition and fees only at the colleges that participate in the plan.

A Coverdell education savings account (ESA) is a tax-advantaged savings vehicle that lets you save money for college and K-12 for a named beneficiary, such as a child or grandchild. Qualified education expenses cover tuition, fees, room and board, books, equipment, computers, tutoring, uniforms, and transportation.

Contribution limits and restrictions

Coverdell ESAs have an annual contribution limit of $2,000. That’s considerably less than you can contribute to 529 plans. Most 529 plans have lifetime contribution limits of $350,000 and up (limits vary by state).

Coverdell ESAs also have income restrictions on who can open an account. To make the full $2,000 annual contribution in 2018, single filers must have a MAGI less than $95,000 (a partial contribution is allowed with a MAGI between $95,000 to $110,000) and joint filers must have a MAGI less than $190,000 (a partial contribution is allowed with a MAGI between $190,000 to $220,000). With a 529 plan, anyone can open an account; no income limits apply.

Coverdell ESAs also restrict the age of the beneficiary. You can’t open a Coverdell account for any beneficiary who is age 18 or older because you Coverdell accounts do not allow any contributions after the beneficiary reaches age 18. (An exception exists if the beneficiary has special needs.) This typically means that you can’t keep contributing to the account once your child starts college. In addition, a Coverdell ESA can’t continue after the beneficiary reaches age 30 (unless the beneficiary has special needs). By contrast, the federal government imposes no age restrictions on 529 plans. However, some states may impose such restrictions of their own (usually only 529 prepaid tuition plans), so make sure to check with your plan administrator.

Income tax treatment

The tax treatment of 529 plans and Coverdell ESAs is generally similar. At the federal level, there is no deduction for contributions made to either a 529 plan or a Coverdell ESA (though states may offer one). Withdrawals from either that are used to pay the beneficiary’s qualified education expenses (called qualified withdrawals) are free from income tax at the federal level. At the state level, whether the withdrawal is income tax free or deductible from income depends on the state you live in. And keep in mind that states may limit their tax benefits to individuals who participate in the in-state 529 plan.

Withdrawals from a 529 plan or Coverdell ESA that are not used for the beneficiary’s qualified education expenses (called nonqualified withdrawals) are also treated similarly. First, you’ll owe income tax on the earnings portion of the withdrawal (you may also owe state income tax). For 529 plans, the person who receives the distribution (typically the account owner) pays the tax, while for Coverdell ESAs, the beneficiary generally pays the tax. Second, you’ll owe a 10% federal penalty on the earnings portion of the withdrawal (you may also owe a state penalty).

Control of the account

As the owner of a 529 account, you decide when withdrawals will be made and for what purpose. You’re also free to change the beneficiary, and as long as the new beneficiary fits the definition of a qualified family member of the previous beneficiary, you won’t be penalized for making the change. As a parent or guardian, you generally have these same rights with a Coverdell ESA, but the exact degree of control may depend on the trustee’s policies. For example, control will sometimes pass to the beneficiary once he or she is no longer a minor. And when the beneficiary (who is not a beneficiary who has special needs) turns age 30, the funds in a Coverdell ESA must be distributed within 30 days. The earnings may be subject to tax and penalty, and the beneficiary will have control of the funds. By contrast, the money in a 529 account can generally stay there as long as you like (though prepaid tuition plans may have restrictions on how long an account can remain open).

Investment options and flexibility

In terms of investment control, Coverdell ESAs have the edge. You can set up a Coverdell ESA with any number of banks, mutual fund companies, and other institutions. And you can customize your portfolio, choosing investments on your own. You’re also typically free to move money among a company’s investments or to transfer your Coverdell ESA from one trustee to another as often as you like. Finally, you can take a withdrawal from your Coverdell ESA and roll it over to a Coverdell ESA with a different trustee. The new account can be for the same beneficiary or for a new one within the same family. You can only do one rollover per year, though, and you must complete the rollover within 60 days to avoid tax and penalty.

By contrast, you lack such investment freedom with a 529 savings plan. When you open a 529 saving plan account, you’ll get to choose one or more investment portfolios offered by the plan, which typically consist of mutual funds tailored to different investment styles. In any case, though, you don’t get to choose the underlying mutual funds held in an investment portfolio — the plan’s professional money managers make those decisions.

Once you’ve invested money in a portfolio, you have limited opportunities to change investment options if you’re unhappy with the portfolio’s investment performance. Generally, you can change the investment options on your existing contributions twice per calendar year, or whenever you change the beneficiary.

But there’s one option that’s mandated by federal law and not subject to a plan’s discretion. You can change the investment option on your existing contributions without penalty by doing a rollover to another 529 plan (savings plan or prepaid tuition plan) without changing the beneficiary. However, you’re limited to one such rollover once per calendar year. If you want to do more than one rollover in a calendar year, you’ll need to change the beneficiary to avoid a penalty and taxes.

Note: With a prepaid tuition plan, your money is generally invested in a trust fund that’s managed by professional money managers. You don’t get to choose a portfolio, and you have virtually no say in how your money is invested. But you are typically guaranteed a minimum rate of return.

Gift tax

You may be concerned about the gift tax consequences of contributing to a 529 plan or a Coverdell ESA. The treatment will be similar in both cases — your contribution is considered a completed gift to the account beneficiary, and so it qualifies for the annual federal gift tax exclusion. This means that you can gift up to $15,000 a year, per person, to an unlimited number of people without triggering federal gift tax.

However, because the annual maximum contribution allowed to a Coverdell ESA is $2,000, you won’t trigger the gift tax rules if this is your only gift to the beneficiary for the year. As for 529 plans, they offer a special gifting feature that’s not available with any other education savings vehicle. Specifically, you can make a lump-sum contribution to a 529 plan of up to five times the annual gift tax exclusion — $75,000 for individual gifts and $150,000 for joint gifts — and avoid gift tax by making a special election on your tax return to spread the gift evenly over five years, provided no other gifts are made to the same beneficiary during the five-year period. And the fact that you’re making a completed gift generally means that those funds are removed from your taxable estate.

Financial aid treatment

The federal financial aid treatment of 529 plans and Coverdell ESAs is identical. Each is considered an asset of the parent if the parent is the account owner (which is a more favorable result than if the account were classified as a student asset). Also, distributions (withdrawals) from either a Coverdell ESA or a 529 plan that are used to pay the beneficiary’s qualified education expenses aren’t classified as either parent or student income, which means that the money is not counted again when it’s withdrawn.

Grandparent-owned 529 plans or Coverdell ESAs aren’t counted as parent assets, but distributions from either account are counted as student income the following year.

Note: The financial aid treatment of 529 plans and Coverdell ESAs is complex and subject to change. You should consult a financial planner experienced in financial aid issues for more information.

Can you have both?

Yes. You can open both a 529 account and a Coverdell ESA for the same beneficiary. And you can contribute to both types of plans in the same year for the same beneficiary. In fact, due to the low annual contribution limit of Coverdell ESAs, it’s hard to imagine saving enough money for college by using only this type of account.

If withdrawals are made from a 529 account and a Coverdell ESA in the same year for the same beneficiary, you’ll need to allocate the qualified education expenses you’re covering between the two accounts. For more information, consult an experienced tax professional.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

529 Plans vs. Other College Savings Options

529 plans can be a great way to save for college, but they’re not the only way. When you’re investing for a major goal like education, it makes sense to be familiar with all of your options.

Mutual funds

Mutual funds are an option to save for college costs. They offer unlimited investment control and flexibility as you can choose from a wide variety of funds that meet your risk tolerance, time horizon, and overall investment preferences. And there are no restrictions or penalties if you sell your shares and use the money for something other than college.

But 529 plans are generally a more powerful tool than mutual funds when it comes to saving for college because they offer federal tax benefits that mutual funds don’t. First, assets in a 529 plan accumulate tax deferred, which means you don’t pay incomes taxes each year on the income earned by the fund’s underlying assets. With mutual funds, you’ll pay income tax every year on the income earned by the fund (dividends and capital gain distributions paid by the fund), even if that income is reinvested. Second, withdrawals from a 529 plan that are used to pay the beneficiary’s qualified education expenses are completely free of federal income tax (and typically state income tax). With mutual funds, you’ll pay capital gains tax on any gain in the value of your fund when you sell your shares.

The main drawbacks of 529 plans is that they offer less investment control and flexibility. Regarding investment control, you’re limited to the investment portfolios offered by the plan (investment portfolios typically consist of groups of mutual funds) and you can change your investment options on your existing contributions only twice per calendar year. This can make it difficult to adjust to changing market conditions. Regarding flexibility, if you use 529 plan funds for non-educational expenses, the earnings part of the withdrawal is subject to income tax and a 10% federal penalty (state income tax and a penalty may also apply).

Keep in mind that both mutual funds and 529 plans involve risk — your ultimate college fund could be worth more or less than the principal you invested.

Coverdell accounts

A Coverdell education savings account (ESA) is a tax-advantaged savings vehicle that lets you save up to $2,000 per year for a beneficiary’s college or K-12 expenses. Qualified education expenses include tuition, fees, room and board, books, equipment, computers, tutoring, uniforms, and transportation. At one time, Coverdell accounts were the only tax-advantaged way to save for K-12 expenses. Now, though, 529 plan funds can be used to pay K-12 expenses, up to $10,000 per year for tuition only.

The tax treatment of Coverdell ESAs and 529 plans is generally the same. Contributions to both accounts accumulate tax-deferred and withdrawals are completely tax free at the federal level (and typically the state level) when used for the beneficiary’s qualified education expenses. For withdrawals used for any other purpose, the earnings portion of the withdrawal is subject to federal income tax and a 10% federal penalty (state income tax may apply as well).

Coverdell accounts offer more investment flexibility than 529 plans because you can generally buy and sell investments in the account whenever you’d like. But Coverdell accounts are much more restrictive than 529 plans. First, the $2,000 annual contribution limit for Coverdell ESAs is much less than the lifetime maximum contribution limit for 529 plans, which is typically $350,000 and up depending on the plan. Second, in order to be eligible to contribute to a Coverdell account single filers must have a modified adjusted gross income (MAGI) under $110,000, and married filers must have a MAGI under $220,000. Another drawback is that you can’t contribute to a Coverdell account for a beneficiary who is 18 or older, unless the beneficiary has special needs. By contrast, 529 plans don’t restrict your ability to contribute based on your income, and most plans let you contribute after the beneficiary reaches age 18.

Custodial accounts

A custodial account is another college savings option. Assets in a custodial account are held in your child’s name and must be used exclusively for your child’s benefit. A custodian (who can be you or another adult) manages the account and invests the money for your child until he or she is no longer a minor (18 or 21, depending on the state). At that point, your child gains complete control of the funds. Custodial accounts are established under either the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). They are similar in most ways but an UTMA account can typically hold certain assets that an UGMA account can’t (states must enact one or the other).

A custodial account is not a tax-deferred account. Earnings, interest, and capital gains generated from assets in the account are taxed every year to your child under special “kiddie tax” rules that apply when a child has unearned income. The kiddie tax rules generally apply to children under age 18 and full-time college students under age 24 whose earned income doesn’t exceed one-half of their support. Under the kiddie tax rules, in 2018 the first $1,050 of unearned income is tax free, the next $1,050 is taxed at the child’s rate, and any amount over $2,100 is taxed using the trust and estate tax brackets.

Generally, a 529 plan gives you more control than a custodial account because as account owner, you decide when the money will be withdrawn and for what purpose; your child doesn’t become the legal owner of the funds at age 18 or 21 as with a custodial account.

But a custodial account might appeal to you for some of the same reasons as mutual funds. Though money in the account must be used for your child’s benefit, that requirement is broader than just college expenses. For example, it could include paying for a gap year or other enrichment activities, a car, computer, etc. Also, your investment choices are virtually unlimited (e.g., stocks, mutual funds, real estate), allowing you to be as aggressive or conservative as you wish, and you can generally buy and sell investments at any time. As mentioned, 529 plans don’t offer this degree of investment flexibility.

U.S. savings bonds

U.S. savings bonds are another possible education savings option. They’re very easy to purchase and backed by the full faith and credit of the federal government. You can purchase bonds in face values as low as $50 ($25 if purchased electronically). Two types of savings bonds, Series EE and Series I bonds, are available. Not only is the interest earned on them exempt from state and local tax at the time you redeem (cash in) the bonds, but you may be able to exclude the interest from federal income tax if you meet the following conditions:

• Your modified adjusted gross income (MAGI) must be below $94,550 if you’re filing single and $149,300 if you’re married filing jointly in 2018 (limits are indexed for inflation every year)
• The bond proceeds must be used to pay for qualified education expenses
• The bonds must have been issued in 1990 or later
• The bonds must be in the name of one or both parents, not in the child’s name
• Married taxpayers must file a joint return
• The bonds must have been purchased by someone at least 24 years old
• The bonds must be redeemed in the same year that qualified education expenses are being paid

Savings bonds offer a low steady rate of return that’s guaranteed. But you may not be able to keep up with college inflation, which has generally averaged between 3% and 5% per year. And despite the potential tax savings, trying to amass a large college fund with regular monthly savings bond purchases can be inconvenient. If you’re interested in making monthly contributions to a college fund, 529 plans let you set up electronic funds transfer from your checking or savings account on a monthly or quarterly schedule.

Traditional and Roth IRAs

Traditional IRAs and Roth IRAs are retirement savings vehicles. However, withdrawals for qualified education expenses are exempt from the 10% premature distribution tax (also called the early withdrawal penalty) that generally applies to withdrawals made before age 59½. So some parents may decide to save for college within their IRAs. In order to be exempt from the early withdrawal penalty, money you withdraw from your IRA must be used to pay the qualified education expenses of you or your spouse, or the children or grandchildren of you or your spouse.

However, keep in mind that even if you’re exempt from the 10% penalty, money withdrawn from a traditional IRA may be subject to federal income tax and possibly state income tax (withdrawals from a Roth IRA are income tax free if certain requirements are met). And, of course, any withdrawals for college expenses will reduce your retirement nest egg, so you should think carefully before tapping your retirement funds.

Trusts

Trusts can be used to save for education expenses, but they can be expensive to establish. There are two types you may want to investigate:

Irrevocable trusts: You can set up an irrevocable trust to hold assets for your child’s future education costs. This type of trust lets you exercise control over the assets through the trust agreement. However, income retained in the trust is taxed to the trust itself at a potentially higher amount. Also, transferring assets to the trust may have negative gift tax consequences.

2503 trusts: There are two types of trusts that can be established under Section 2503 of the Tax Code: the 2503©) “minor’s trust” and the 2503(b) “income trust.” The specific features and tax consequences vary depending on the type of trust used, and the details are beyond the scope of this discussion. Suffice it to say that either type of trust is much more costly and complicated to establish and maintain than a 529 plan. In most cases, a 529 plan is a better way to save for college.

Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

Comparison of College Savings Vehicles

529 Plans: Prepaid Tuition Plans

This table provides information on 529 prepaid tuition plans that are currently accepting new enrollments. The first section covers state-sponsored plans; the second covers college-sponsored plans.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

State-Sponsored Prepaid Tuition Plans
State	Name of plan, manager, contact information	Residency restrictions	State tax benefits
FL	Florida Prepaid College Plan Florida Prepaid College Board myfloridaprepaid.com (800) 552-4723	Beneficiary or parent/guardian must be a Florida resident for at least 12 months prior to enrollment	Florida has no state income tax
IL	College Illinois! 529 Prepaid Tuition Program Illinois Student Assistance Commission collegeillinois.org (877) 877-3724	Account owner or beneficiary must be an Illinois resident for at least 12 months prior to enrollment	Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap
MD	Maryland Prepaid College Trust College Savings Plans of Maryland maryland529.com (888) 463-4723	Account owner or beneficiary must be a Maryland or District of Columbia resident at time of enrollment	Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions
MA	U.Plan Massachusetts Educational Financing Authority mefa.org/uplan (800) 449-6332 Note: This plan does not meet the technical requirements of Section 529 of the Internal Revenue Code	Open to all	The U.Plan issues Massachusetts general obligation bonds that are exempt from federal and state income tax and accepted at participating Massachusetts institutions in payment of tuition
MI	Michigan Education Trust MET Board of Directors and Treasury Department michigan.gov/setwithmet (800) 638-4543	Beneficiary must be a Michigan resident at time of enrollment	Qualified withdrawals are tax free, and all contributions to in-state plan are deductible
MS	Mississippi Prepaid Affordable College Tuition Program (MPACT)  Mississippi Treasury Department treasurerlynnfitch.ms.gov/collegesavingsmississippi (800) 987-4450	Account owner or beneficiary must be a Mississippi resident at time of enrollment	Qualified withdrawals are tax free, and all contributions to in-state plan are deductible
NV	Nevada Prepaid Tuition Program Board of Trustees of the College Plans of Nevada and State Treasurer nvprepaid.gov (888) 477-2667	Account owner or beneficiary must be a Nevada resident at time of enrollment, or account owner must be an alumnus of a Nevada college	Nevada has no state income tax
PA	Pennsylvania 529 Guaranteed Savings Plan  State Treasury pa529.com (800) 440-4000	Account owner or beneficiary must be a Pennsylvania resident at time of enrollment	Qualified withdrawals are tax free, and contributions to any state’s 529 plan are deductible, up to a cap
TX	Texas Tuition Promise Fund NorthStar Financial Services Group texastuitionpromisefund.com (800) 445-4723	Beneficiary must be a Texas resident or have a parent who is a Texas resident and the account owner at time of enrollment	Texas has no state income tax
VA	Virginia 529 prePAID  Virginia College Savings Plan virginia529.com/prepaid (888) 567-0540	Account owner, beneficiary, or parent of a nonresident beneficiary must be a Virginia resident or member of U.S. military who is stationed in Virginia at time of enrollment	Qualified withdrawals are tax free, and contributions to in-state plan are deductible, up to a cap, with an unlimited carryover of excess contributions
WA	Guaranteed Education Tuition (GET) Washington State Student Achievement Council get.wa.gov (800) 955-2318	Account owner or beneficiary must be a Washington resident at time of enrollment	Washington has no state income tax
Private College-Sponsored Prepaid Tuition Plans
	Private College 529 Plan Tuition Plan Consortium, LLC privatecollege529.com (888) 718-7878	Open to all	Varies from state to state; contact a tax professional

Advantages and Disadvantages of 529 Plans

Note: Investors should consider the investment objectives, risks, charges and expenses associated with 529 plans carefully before investing. More information about 529 plans is available in the issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated.

Advantages and Disadvantages of Coverdell Education Savings Accounts

529 Plans vs. Coverdell Education Savings Accounts

¹ A 10% federal penalty is assessed on the earnings portion of all nonqualified withdrawals from a 529 plan and a Coverdell ESA. The penalty generally doesn’t apply to nonqualified withdrawals made due to the beneficiary’s death, disability, or receipt of a tax-free scholarship (to the extent of the scholarship’s value).

² The annual gift tax exclusion is currently $14,000. However, you may contribute up to $70,000 to a 529 plan in one year (for the same beneficiary) and not owe gift tax if you elect to spread the gift over a five-year period and you make no additional gifts to the beneficiary during that period.

³ Qualified family members include children and their descendants, stepchildren, siblings, stepsiblings, parents, stepparents, nieces, nephews, aunts, uncles, first cousins, and in-laws of the original beneficiary.

Note: Investors should consider the investment objectives, risks, charges and expenses associated with 529 plans carefully before investing. More information about 529 plans is available in the issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits. As with other investments, there are generally fees and expenses associated with participation in a 529 savings plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated.

The availability of the tax or other benefits mentioned above may be conditioned on meeting certain requirements.

What is the college inflation rate?

The college inflation rate refers to the annual increase in college tuition and fees, similar to the way the general inflation rate refers to the annual increase in the cost of living. The college inflation rate is typically in the range of 3% to 5% for both private and public colleges.

For parents trying to keep up with their child’s college fund, it’s important to choose investments for college savings that keep pace with college inflation. You can use the college inflation rate for a given year or the average rate of inflation over the past decade to help project college costs in the future. Be aware, however, that the more years your child has to go until college, the greater likelihood that your cost estimate will need to be revised at a later date.

What expenses are included in the annual cost of college?

To most parents, the annual cost of college simply refers to tuition and room and board. To the federal government, however, the annual cost of college means the cost of attendance. Twice per year, the federal government calculates the cost of attendance for each college, adjusts the figure for inflation, and, if your child is applying for financial aid, uses this number to determine your child’s financial need.

Five categories of expenses are used to determine the cost of attendance at a particular college:

• Tuition and fees: Same for all students at private colleges but can vary at public colleges, depending on whether the student is in-state or out-of-state
• Room and board: Can vary by student, depending on the meal plan your child selects and whether he or she lives on or off campus
• Books and supplies: Can vary by student, depending on your child’s courses and his or her requirements
• Transportation: Can vary greatly by student, depending on where your child lives in relation to the school
• Personal expenses: Can vary by student (e.g., health insurance, spending money, clothing)

Tuition, fees, room, and board (referred to as “direct costs”) are calculated using the college’s figures. For books, supplies, transportation, and personal expenses (referred to as “indirect costs”), the federal government sets a monetary figure even though the exact expenses incurred will depend on the individual student. Thus, depending on these variables, your child’s actual cost may be slightly higher or lower than the cost used for official purposes like financial aid determinations.

If you’re interested in obtaining the monetary amount allotted to each category for a particular college, contact that college directly.

Should I use my 401(k) to fund my child’s college education?

You can, but it isn’t your best option. Your 401(k) plan should be dedicated primarily to your retirement.

There are two primary drawbacks to using your 401(k) for college funding. First, if you withdraw funds from your 401(k) before you are 59½, you will owe a 10% premature distribution penalty on the withdrawal. This penalty is in addition to income taxes you will owe on the withdrawal. Second, frequent dips into your 401(k) reduce the amount of money you ultimately have available to reap the benefits of compounding and tax deferral. This, in turn, reduces the overall funds for your retirement.

If you really need to use your 401(k) funds to pay for college, a better option might be to borrow from your plan if your plan allows loans. Plan loans are not taxed or penalized, as long as you repay the funds within a specified time period. But make sure you compare the cost of borrowing college funds from your plan with other finance options. Although interest rates on plan loans may be favorable, the amount you can borrow is limited, and you generally must repay the loan within five years. In addition, some plans require you to repay the loan immediately if you leave your job. Your retirement earnings will also suffer as a result of removing funds from a tax-deferred investment.

If you want to save for college in a retirement vehicle, consider using a traditional IRA or Roth IRA instead. With IRAs, you will not owe a 10% premature distribution penalty on withdrawals you make before age 59½ if the money is used to pay your child’s qualified college expenses.

Should I save for college in my name or my child’s name?

There are three potential drawbacks to saving in your child’s name: the kiddie tax, federal financial aid rules, and control issues.

First, the kiddie tax. At one time, saving money in a child’s name was recommended because of the tax saving opportunities that resulted when children were taxed at their own rate on all their unearned income. However, Congress partially closed this loophole some years ago with passage of special rules commonly referred to as the “kiddie tax” rules. Under the kiddie tax rules, a child’s unearned investment income over a certain amount is taxed at trust and estate income tax rates. In 2018, this amount is $2,100 — the first $1,050 is tax free and the next $1,050 is taxed at the child’s rate. The kiddie tax rules significantly reduce the tax savings potential of a child holding assets in his or her name.

The kiddie tax rules apply to: (1) those under age 18, (2) those age 18 whose earned income doesn’t exceed one-half of their support, and (3) those ages 19 to 23 who are full-time students and whose earned income doesn’t exceed one-half of their support. To lessen the impact of the kiddie tax, choose tax-free or tax-deferred investments in which the annual expected income does not exceed the threshold amount of $2,100.

Second, the federal financial aid rules have a more negative impact on child assets than parent assets. Under the current federal aid formula, a child must contribute 20% of his or her assets to college costs each year, whereas parents must contribute 5.6% of their assets each year. So $10,000 in your child’s bank account would equal a $2,000 contribution from your child, but that same $10,000 in your bank account would equal a $560 contribution from you. The more assets a child has, the more he or she will be expected to contribute to college costs, and the less financial aid he or she will be eligible for.

Finally, there is the control issue. Do you want your child to have control over college funds? For example, some parents open a custodial account for their child (UTMA/UGMA) to save for college. However, with a custodial account, when the child reaches the age of majority (18 or 21, depending on the state), he or she gets full control over the money in the account and can use the money for anything, not necessarily college. Some parents aren’t willing to relinquish this control to their child.

For all these reasons, it’s generally recommended that parents save for college in their own names, not their children’s names.

Help! My child is two years away from college and we haven’t saved much. What should we do?

Your late start means you’ve missed most of the best opportunities to grow the money you have. With only two years until your child starts college, you’ll need to refine the college selection process, accumulate enough of a down payment for the early college bills, and establish a savings plan for the later college years. Here are some constructive steps you can take.

First, help your child investigate schools that provide a good value. Some less expensive state universities and second-tier private colleges may offer better programs than their more expensive private counterparts. Think creatively. Your child could attend a nearby school and live at home for a year or two to save money on room and board. He or she could attend a community college for two years and then transfer to a private four-year college. Or, your child could consider cooperative education, where semesters of academic work alternate with semesters of paid work. If your finances are severely limited, your child might consider taking a year off before starting college.

Second, learn all you can about financial aid. Do a dry run through the federal government’s financial aid application to determine whether your child is likely to qualify for financial aid, and, if so, for how much. When you’ve zeroed in on a few colleges, examine their financial aid statistics. For example, what percentage of students receive financial aid? What percentage of the average package consists of loans? What percentage of a student’s financial need is generally met — 100%? 75%? Does the college offer merit scholarships? Use a net price calculator on a college’s website to get an idea of how much grant or scholarship aid your child might receive at a particular college based on your financial information.

Third, start investigating potential scholarships. There are a number of websites where your child can type in his or her interests, abilities, and goals to obtain a list of relevant scholarships. However, outside scholarships generally make up only a small portion of a student’s overall aid package, and the process can be very competitive. So don’t make the mistake of thinking that a private scholarship will magically cover most of your child’s college expenses. It’s important that this search be made in addition to, not in place of, the quest for federal and college-sponsored financial aid.

Fourth, examine any current financial resources that you can draw on for the early college bills. Do you have savings accounts, stocks, mutual funds, or cash value life insurance? Can you pay a portion of the tuition bills from current income? Can you increase the family income by getting a second job or having a previously stay-at-home spouse return to the work force? If you’re still short, you’ll need to investigate a personal loan, home equity loan, or federal Parent PLUS Loan. In other cases, you may need to tap your retirement accounts, though this is generally recommended only as a last resort.

Finally, you’ll need to start earmarking as much of your current income as you can for college bills that will come due in four or five years, when your child is a junior or senior in college. Because you’ll need the money relatively soon, you should avoid high-risk investments. Instead, choose a low-risk, stable investment, such as a certificate of deposit that is timed to mature when you need it, or a money market mutual fund.

Are 529 plans a good way to save for college?

Yes, they can be an excellent way to save for college. 529 savings plans let you save money for college in an individual investment account that offers federal tax advantages. 529 plans are established by individual states and managed by an experienced financial institution designated by the state. Plans may have slightly different features but essentially work the same way.

You (or anyone else) open an account in your child’s name and contribute as much money as you want, subject to the plan’s lifetime limit. You select from a variety of investment portfolios depending on your risk tolerance or other factors that are important to you. Most plans offer age-based portfolios whose underlying investments automatically become more conservative as your child gets closer to college.

529 savings plans are popular because they combine many desirable tax features with the ability to use the money at any accredited college in the country or abroad. Your contributions grow tax deferred and withdrawals are tax-free at the federal level if used to pay the beneficiary’s qualified education expenses. Many states also add their own tax benefits, such as a tax deduction for contributions and exemption of the earnings from state income tax. However, if a withdrawal isn’t used to pay the beneficiary’s qualified education expenses (known as a nonqualified withdrawal), the earnings portion of the withdrawal is subject to a 10% federal penalty and is taxed as income at the rate of the person who receives the withdrawal (a state penalty and income tax may also apply).

There are no income limits that determine whether you are eligible to open a 529 account — everyone is eligible. And if your child decides not to go to college or gets a scholarship, the money in the account can be transferred to a qualified family member without penalty.

But investment returns aren’t guaranteed. By law, 529 plans are authorized — but not required — to let you change the investment options on your existing contributions twice per calendar year. (Plans are also free to let you change your investment option for future contributions at any time.) If your plan doesn’t provide this flexibility, then you are allowed by law to roll over your existing 529 plan account to a different 529 plan (savings plan or prepaid tuition plan) without penalty once per calendar year.

You are not limited to your own state’s 529 savings plan. States generally allow anyone to participate in their plan. You might choose a different state’s plan for a variety of reasons, such as more investment options, a better track record for investment returns, lower fees, or better customer service. However, if you join another state’s 529 plan, make sure to find out if you will be giving up any 529 tax benefits offered by your state because some states limit their tax benefits to the in-state 529 plan.

Note: Investors should carefully consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. Specific information is available in each plan’s official statement. Keep in mind that there is the risk that 529 plan investments may not perform well enough to cover college costs as anticipated. Also consider whether your state offers any 529 plan state tax benefits and whether they are contingent on joining your own state’s 529 plan.

Can I invest in any state’s 529 plan, or am I limited to my own state’s plan?

529 savings plans are generally open to residents of any state, but 529 prepaid tuition plans are limited to state residents only. Why might you decide to open an account in another state’s 529 savings plan? That plan may offer a wider range of investment options, lower fees, better customer service, and a user-friendly website. Keep in mind that if you join another state’s 529 plan, you may not be eligible for any tax benefits offered by your state because some states restrict 529 tax benefits to residents who join the in-state plan.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Is there an income limit on who can open a 529 account?

No. People of any income level are able to open and contribute to a 529 plan account.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Can more than one 529 account be opened for the same child?

Yes. You (or anyone else) can open multiple 529 accounts for the same beneficiary, as long as you do so under different 529 plans (savings plan or prepaid tuition plan). For instance, you could open a 529 savings plan account with State A and State B for the same beneficiary, or you could open a savings plan account and a prepaid tuition plan account with State A for the same beneficiary.

Also, keep in mind that if you do open multiple 529 accounts for the same beneficiary, each plan has a limit, and contributions can’t be made after the limit is reached. Some states consider the accounts in other states to determine if the limit has been reached. For these states, the total balance of all plans (in all states) cannot exceed the current year’s maximum contribution amount. Check the specific rules of any plan you’re considering.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

How do I enroll in a state’s 529 plan?

Contact the plan administrator that runs the 529 plan that you want to join. All plans have websites and toll-free numbers to help you get the information you need. Plan administrators may be state agencies or companies established solely for the purpose of running a 529 plan, or they may be investment firms. In any case, the plan administrator operates under the authority of each state government, such as the state treasury department. The plan administrator will send you a packet of information that includes enrollment materials, along with a program description. Read the information thoroughly and make sure you understand the plan’s rules before you enroll.

In addition, be sure to check the enrollment period for the plan. Many states offer open enrollment for 529 savings plans, meaning you can join the plan at any time. Other states may have shortened enrollment periods, such as October to January, for prepaid tuition plans.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

What happens if I open a 529 plan in one state and then move to another state?

Essentially nothing, if you have a 529 savings plan. You can leave the account funds in your former state’s plan with no penalty, and then tap those funds at college time. Alternatively, you can roll the assets over from your old state’s 529 plan to your new state’s plan if both plans allow it, keeping the same beneficiary (you can only do a rollover once per year). Check the details of each plan carefully before you start any transfer.

Some 529 plans may require a minimum time period, such as one year, before withdrawals (including rollovers) can be made from an account for any reason. Again, check both plans to make sure there are no withdrawal limitations.

One advantage of a rollover is that you can reallocate your 529 funds to a different investment portfolio (or portfolios) when you join the new plan. So, you might be able to invest more or less aggressively, depending on your personal situation and market factors.

Finally, if you have a prepaid tuition plan and you move to another state, contact your plan administrator. Prepaid tuition plans are geared to state residents and funds are restricted to in-state public colleges. Now that you’ve moved out of state, there may be consequences.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Can I move funds from my Coverdell account to a 529 plan?

Generally, yes. A rollover contribution from a Coverdell education savings account to a 529 plan is considered a qualified education expense for Coverdell purposes, provided the beneficiary is the same for both accounts. In this case, the transfer from the Coverdell account to the 529 plan will be nontaxable.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Can I use 529 plan funds to pay my child’s college expenses in the same year I claim an education tax credit?

Yes. You can use 529 plan funds to pay for your child’s college expenses in the same year you claim an education tax credit such as the American Opportunity credit or Lifetime Learning credit. But there’s a caveat. You can’t use the same college expenses to qualify for the federal tax-free 529 withdrawal and the tax credit; the expenses you use to qualify for each must be different. Otherwise your 529 withdrawal will not be free from federal income tax.

For purposes of your 529 plan, your qualified education expenses are first reduced by expenses used to compute your American Opportunity credit or Lifetime Learning credit. The remaining expenses may be paid with the funds you withdraw from the 529 plan (and you won’t pay any federal income taxes on those funds). You will pay federal income tax (and, in most cases, a penalty and maybe some state income taxes) on any part of your 529 plan withdrawal that remains after paying these expenses.

Another option is to waive the American Opportunity credit or Lifetime Learning credit. This waiver may make sense if the value of the education credit is less than the value of federal income tax-free (and penalty-free) withdrawals from your 529 account.

For more information, see IRS Publication 970, Tax Benefits of Education.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

If I cash in U.S. savings bonds and contribute the proceeds to a 529 plan, can I still avoid paying tax on the proceeds?

Yes. You can roll over the U.S. savings bonds into a 529 plan if you meet all of the requirements for income-tax-free use of the savings bonds. If you own certain Series EE or Series I bonds, you may redeem them and exclude the interest from your income if you use the proceeds for qualified education expenses (tuition and fees) and if your modified adjusted gross income is below a certain level in the year of the redemption.

Rolling the proceeds over to a 529 plan is considered the equivalent of using the proceeds for qualified education expenses. So, meeting the income limitations in the year of the rollover will be the key to avoiding tax on the proceeds of the savings bonds.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

I know I can take a loan from my 401(k), but can I borrow from my 529 plan?

No, federal rules do not allow loans against 529 plan funds. Similarly, you can’t use money in your 529 account as security (collateral) for a loan with a bank or other financial institution.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Can I transfer funds from my child’s custodial account to a 529 plan?

Yes, you can. You have two potential options. The first is to liquidate the assets in an UTMA/UGMA custodial account and invest the proceeds in a 529 plan. The second way is to transfer existing UTMA/UGMA assets to a 529 plan.

Before looking at these options, keep in mind that all gifts to an UTMA/UGMA custodial account are considered irrevocable gifts to the child who is named as beneficiary of the account. Once a gift is made, the custodian (usually the parent) can withdraw funds only for the child’s benefit. Funding a 529 plan fits this requirement, provided the beneficiary of the 529 plan is the same beneficiary as the custodial account.

So, regarding the first option, you can liquidate the assets in the custodial account, close the custodial account, and invest the proceeds in a 529 plan. (Keep in mind, though, that you may incur tax liability when liquidating assets in the custodial account.)

The second option of keeping the custodial account intact and transferring the assets to a 529 plan is a bit trickier. Whether this type of transfer is allowed usually depends on the rules of the specific 529 plan. Keep in mind that federal law requires all contributions to a 529 plan to be made in cash. Therefore, all assets in a custodial account would first need to be converted to cash if they were not already (this may trigger income tax liability).

In either case, liquidating the custodial account or transferring the assets (cash) in the custodial account, you are still technically bound by the rules of the custodial account. This means that you can’t change the beneficiary of the 529 plan, because gifts to a custodial account are considered irrevocable gifts to the beneficiary. In addition, you must relinquish control of the 529 plan to your child when he or she reaches the age of majority (18 or 21, depending on state law), because this is what happens with a custodial account. And finally, all future contributions you make to the 529 plan will be treated as UTMA/UGMA custodial account contributions, which means they will be considered irrevocable gifts to the beneficiary. Contact your 529 plan administrator for more information.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer’s official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

What are the rules for Coverdell education savings accounts?

A Coverdell education savings account is a particular type of savings vehicle that allows you to invest for the education costs of a child or other beneficiary. Coverdell ESAs offer tax-deferred savings opportunities.

You can contribute up to $2,000 per beneficiary, assuming you meet the income requirements. You can even make a contribution as late as April 15 of the following year, and it will be credited to the current taxable year. Your contributions aren’t tax deductible, but any distributions used to pay qualifying education expenses (which include elementary and secondary school expenses) will be completely tax free. (Generally, distributions are tax free if they are not more than the beneficiary’s education expenses for the year.) But, if a distribution from a Coverdell ESA isn’t used to pay qualifying education expenses, the portion of the distribution that represents earnings will be included in the beneficiary’s taxable income and is also subject to an additional 10 percent penalty.

To make a full contribution to a Coverdell ESA, single filers must have a modified adjusted gross income (MAGI) of less than $95,000, and joint filers must have a MAGI of less than $190,000. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000, and for joint filers with a MAGI between $190,000 and $220,000.

Generally, the beneficiary of a Coverdell ESA can be anyone under age 18. Once that person reaches 18, you can no longer make contributions on his or her behalf. The exception is if the beneficiary is a special needs child, in which case you can still contribute to the account after the beneficiary reaches age 18.

You can set up separate Coverdell ESAs for different beneficiaries, a key advantage if you have more than one child or grandchild. You can even roll a Coverdell ESA over into another Coverdell ESA for either the same beneficiary or a family member of that beneficiary. However, no more than $2,000 a year can be contributed to all Coverdell ESAs for the benefit of any one beneficiary. For example, if you and Grandpa each open a Coverdell ESA for your child, your combined contributions for the year can’t exceed $2,000. Also, any funds remaining in the account when the beneficiary turns 30 must be distributed at that time (unless the beneficiary is a special needs individual), resulting in income tax and possibly a penalty on the earnings portion of the distribution.