3 Popular Myths About Saving for College

Source: Thinkstock

Source: Thinkstock

Paying for college is one of the heaviest financial burdens weighing on families. Tuition prices have more than doubled over the past decade, while debt loads continue to reach new record highs with each passing school year. Making matters worse, several misconceptions still surround one of the most efficient college savings tools.

In order to help shoulder college costs, Americans should consider 529 plans, which are tax-advantaged investment plans to encourage saving for future higher education expenses. They are sponsored by states, state agencies, or educational institutions, and are authorized by Section 529 of the Internal Revenue Code. All 50 states and the District of Columbia offer access to at least one type of a 529 plan. The plans use after-tax contributions and grow tax-free.

A 529 plan is relatively simple. The account holder establishes an account for the student (beneficiary) and selects how contributions will be invested over time. In general, there are degrees of risk tolerances to choose, and investment options often include stock mutual funds, bond mutual funds, money market funds, and age-based portfolios that become more conservative as the beneficiary nears college age. Account holders may change investment options once per year, and many plans have contribution limits in excess of $200,000. There are no income limits for account holders.

I recently spoke to Jeff Howkins, CEO of Ascensus College Savings, to gain a better understanding of 529 plans. Let’s take a look at three popular misconceptions facing people trying to save money for education purposes.

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1. College savings will ruin financial aid

Many parents believe that saving for college with 529 plans will significantly impact their child’s financial aid package. However, if the account owner of the 529 plan is a parent, the plan is considered a parent’s asset, making the impact on financial aid minimal. Generally, 529 plans are counted at a rate of only 3-6 percent of its value for the Expected Family Contribution as calculated by the Free Application for Federal Student Aid (FAFSA).

The situation is a bit more complicated for grandparents owning 529 plans. On the surface, 529 plans or other assets owned by grandparents are not reportable on the FAFSA application. However, if a grandparent distributes money to the beneficiary from the 529 plan, it’s counted as student income on the following year’s FAFSA. In order to avoid this drawback, a grandparent would need to wait until the student’s senior year to distribute funds, since the student would not need to fill out the FAFSA for the following year. This strategy may not work at some schools that require additional information on family assets.

Nonetheless, the benefits of saving for college ahead of time outweigh borrowing. Howkins offers the chart above with two hypothetical scenarios. Scenario 1: Terry’s parents start investing $100 a month into a 529 plan account right after Terry’s birth. In 18 years, they could potentially save over $35,000. Scenario 2: Terry has to borrow $35,000 to attend college. Terry could be faced with a monthly payment of $406 for 10 years (or $48,720).

Source: Thinkstock

Source: Thinkstock

2. You must take the traditional route

Life is full of surprises. Thankfully, there are different ways to react to them. All 529 savings plans grow tax-free from federal and state income taxes, and withdrawals are not taxed as long as the funds are used on qualified expenses, including tuition, room and board, mandatory fees, books, and computers. Non-qualified expenses are subject to income taxes and a 10 percent penalty on the earnings. This leads some people to believe that 529 plans are useless if the beneficiary doesn’t attend college, but that’s not the case.

Howkins notes that you can use money from 529 plans on any eligible two- or four-year colleges, vocational schools, and technical schools. If the child doesn’t attend a higher education facility, the plan can be rolled over to another qualified family member, including the beneficiary’s spouse, child, step-child, sibling, step-sibling, niece or nephew, aunt or uncle, and several more. Most states have no age limit for when the money has to be used. If your child receives a full ride for college, the 10 percent penalty is waived and you only pay income tax on the account’s earnings if you decide to cash out.

Source: Thinkstock

Source: Thinkstock

3. You have to make a lot of investment decisions

Investing money can be a daunting process, but most 529 plans offer age-based and individual options to keep it simple yet customizable for your risk tolerance.

Howkins explains that, “Age-based options are one-step, ready-made portfolios based on your designated beneficiary’s age and your risk tolerance. As the student gets closer to college-age, the portfolios automatically reallocate your savings to become more conservative. Individual portfolios allow you to create your own college savings investment strategy. A variety of investment portfolios, spanning asset types and risk profiles, give you a range of choices from which to choose. Your investment will remain fixed until you decide to change it.”

As always, you need to do your own homework, especially when choosing 529 plans. You do not have to select the 529 plan offered by the state you reside in, but there might be additional tax benefits if you do, as many states offer a tax deduction on contributions. You should also pay attention to fees. Interestingly, Vanguard announced expense ratio reductions earlier this month that will save an estimated $2 million per year for beneficiaries. Many state 529 plans offer Vanguard investment options, which are routinely the lowest costing funds in the industry.

Follow Eric on Twitter @Mr_Eric_WSCS

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