50 Shades of 529’s: What College Plan Dominates?

Eric’s Note: Tax benefits are specific to Alabama. Originally published at www.mcclainlovejoy.com: http://wp.me/p31Bd2-w9

Does the thought of a $100,000 college bill for one kid leave you feeling out of control? You can use a 529 college savings plan to save and pay for college in a tax preferential way

529  is tax code section which enables states to setup and offer college savings accounts. They come in two flavors–Prepaid Tuition plans, which we generally suggest you  avoid.

Ccontributory plans or 529 college savings accounts which operate like a 401k/403b retirement plans with contributions dedicated to a single goal: paying for college. With college savings accounts you make contributions, select the investments, and  maintain control of the account. Contributions may yield  state tax benefits, but won’t save you on federal taxes right away.

Withdrawals on the other hand, if used for qualified education expenses,  are free from federal taxation, penalties, and in some cases state income taxation. Each state has it’s own college savings plan and some states offer “advisor” plans and “direct” plans, where you purchase and set up the plans yourself or with the help of a fee-only financial planner.

Should you have a 529 Plan?

Make sure your financial house is in order first. While your kid(s) may appreciate your paying  for college, most won’t appreciate caring for a destitute parent while raising kids of their own. Consider your unique financial situation before opening a 529 college savings plan:

  1. Is your financial house in order? This includes reviewing your insurance coverage(s), your retirement plan, your investment strategy, and estate plans. You should also review your debt, spending, & tax situation,–and all before opening a college savings plan.

  2. How much will you pay? There is no right or wrong answer, but you do not owe your child a fully funded college education. If fact, requiring them to have skin in the game by working, or earning scholarships may provide just the right incentive so they’ll be successful.

  3. Consider savings alternatives. Such as a “Family 529”–one account you’ll use for multiple beneficiaries, Roth IRAs–using your basis, your home–using equity lines of credit or just a plain investment account which carries no restrictions. Each of these is a viable options and may be preferential depending on your unique circumstances.
How much should you save for college?

Say you had baby in May and your goal is accumulate enough for $10,000 in today’s dollars for 2 years at Jefferson State Community College. Assuming a 5% inflation rate and and 7.5% average rate of return, you need to save:

$101 per month for 18 years

Perhaps you’d like to save enough to pay for 4 years of college at UA or Auburn while living on campus. Assuming a per year cost of $24,000 in today’s dollars and assuming the same 5% inflation rate and 7.5% average rate of return, you’d need to save:

$454 per month per month for 18 years. Ouch!

You can use the calculator to figure how how much you should save for your particular goal. Often though, it’s an income question as folks usually cannot afford to save the entire amount and save for retirement, payoff a mortgage…

Source: World’s Simplest College Cost Calculator

What’s the best 529 College Savings Plan?

Low fees & great investment options make the Utah plan our favorite.

We look for three thing when evaluating a  college savings plans:

  • Low plan fees
  • Great investment options
  • Tax deduction or credit (maybe)

We prefer the lower fees you’ll usually find with index funds such as those offered by Vanguard & Dimensional Fund Advisors.

Lower fees=More returns

Investment options – we prefer asset class type investments. Rather than trying to “beat the market” we recommend focusing on gaining the most return through broad diversification, periodic rebalancing, cost control and enhanced indexing – something you’ll find the in the DFA funds and to a lesser extent the Vanguard funds.

The Utah Plan has access to both Vanguard and Dimensional Fund Advisors (DFA). DFA forms the core of our client equity investments and I feel that, overtime, DFA should produce higher risk adjust returns.

Lastly, and depending on where you live, you may qualify for a state income tax deduction or credit.

In Alabama you’ll need the College Counts plan in order to receive a tax deduction for contributions, but we suggest giving up the Alabama deduction now and using the Utah plan because Alabama (currently) offers a deduction for contributions and rollovers. So you can use whatever plan you like and when it comes time to pay for college you’ll trickle those dollars into your Alabama plan, receive a deduction, and avoid state income taxes on the 529 distributions.

You can read the Alabama College Counts 529 Tax Q&A below:

 

 

About the author

Eric J. McClain, CFP®

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