Funding college education is one of the highest financial priorities of the dentists I encounter. Among the questions I hear are:
- Should I open 529 college savings accounts for my children?
- Which state's plan is the best?
- How about an education IRA?
This article will attempt to answer these questions and give an overview of the college funding landscape.
There is good reason for dentists to be concerned about how best to help pay college costs. College is expensive and projected to become more so. Currently tuition, room and board at the University of Minnesota is approximately $11,000 a year. At Carleton College, the cost is $31,000. College costs increase at about twice the rate of inflation, and are averaging five to six percent.
Plan of Attack
The first element to consider when planning for a college fund is answering the philosophical question: What role do I want to take in financing my children's post-secondary education?
Some parents believe that their children will be best served by paying for their own education, as this will help them value it more and perhaps not "take it for granted." Other parents take an intermediate position, along the lines of, "We will finance the education up to the expense level of a state school, and if my children choose to go to private colleges, they will need to cover the difference by working, securing loans etc." Finally, there are those parents who anticipate covering all the expenses involved in college and even postgraduate study.
How a given individual chooses to approach the college funding question will be, at least in part, dictated by how much of the child's total expenses he or she feels obligated to cover.
Much of the recent interest in how best to save for college has been generated by the introduction of 529 college savings plans. I will begin with an explanation of what these plans are and how they have revolutionized the way in which parents will finance post-secondary education.
A 529 plan allows the account owner to deposit after-tax money and then have this nest egg grow tax-free providing it is ultimately used for qualified education expenses. It is like having a Roth IRA without the annual contribution limits or income limits that this vehicle imposes.
529 plans are state-sponsored tuition plans. States have contracted with at least one investment provider to offer these plans. For instance, Minnesota's plan is with TIAA-CREF; Delaware's is with Fidelity Investments.
Taking the First Step
How do you open a 529 account?
If you have three children, you would choose the state's plan you prefer and open an account for each child. You may use any state's plan you like - e.g., you may be a Minnesota resident, use Nebraska's 529 plan, and your child may attend college in Massachusetts. You may, as well, open a 529 account for any beneficiary you choose: child, grandchild, nephew, neighbor Ñ even for yourself!
Each state's plan states a maximum amount you are allowed deposit. These range from $150,000 to $250,000 per beneficiary. Deposits to the 529 are counted as gifts, and are, therefore, subject to the annual gift limit of $11,000. There is, however, a special provision for 529 plans whereby you may gift $55,000 in one year and have this count for five years' worth of annual exclusions. Therefore, a couple with three children could start their 529 accounts by gifting $110,000 to each child's account as long as they don't add new money until year six. Anyone Ñ grandparents, godparents, uncles, aunts Ñ may add money to these accounts as well.
Eggs and Baskets
What about the investments offered in 529 accounts?
This is probably the area of greatest differentiation among the plans. Some states have limited options such as one cash account, one bond investment and one stock investment. Other states offer a much broader choice, such as the Virginia plan, which allows the money to be allocated among 21 different investments.
In addition to these choices, many states offer an age-matched investment allocation. For example, when a child is between the ages of three and six years old, 60 percent of the account is automatically invested in stock and 35 percent in bonds. The allocation becomes gradually more conservative as the child gets older, so that when he or she is between the ages of 15 and 18, the allocation may be 15 percent stocks, 35 percent bonds and 50 percent cash. The investment mix becomes more conservative as the time horizon before entering college shortens and that first tuition payment is due.
With 529 plans, the account owner maintains a great deal of control. He or she controls when and how the money will be spent. An account owner is allowed to change the beneficiary of the account once a year. Account owners may also change the investments selected and may even choose to move to another state's plan once a year.
And an Asterisk
What are the alternatives to 529 plans?
One is the Coverdell Education Savings Account, formerly known as the Education IRA. Similar to the 529, it allows the account owner to pay $2,000 of after-tax money into a child's account in a year. The gains will not be subject to taxation if used for the aforementioned qualified education expenses.
There are several drawbacks to the Coverdell. One is the relatively modest amount that can be contributed each year, although it is allowable to contribute to both a Coverdell and a 529 for the same beneficiary in the same year. Another drawback is that if the money is not used for education expenses, it will eventually go to the child, not to the account owner as it does with the 529. Finally, because the money in a Coverdell is counted as an asset of the child's for financial aid purposes, it can have a more adverse effect on qualifying for financial aid than many other forms of college savings, including the 529.
No Place Like It ...
If you choose to open a 529 account, it is wise to look at your home state's plan first, as there may be tax advantages. For instance, in Minnesota there is a matching grant. Account beneficiaries from Minnesota families with incomes of $50,000 or less may be eligible for a matching grant of up to 15 percent of their contributions during the year, up to a maximum of $300. Account beneficiaries from Minnesota families with an income between $50,001 and $80,000 may be eligible for a matching grant of up to five percent of their contributions to the plan during the year, again to a maximum of $300.
Q and A
There are a number of questions I am often asked about 529 plans. Among them are:
What happens if my child doesn't go to college?
First off, it is important to realize that the money may be used for more than just four-year colleges. It may be used at technical schools as well. If a beneficiary does not use the money in the account, the account owner can roll the money to any relative of the original beneficiary, including his or her sibling, cousin and so forth. The owner may even make him- or herself the beneficiary and could potentially use the money for qualifying continuing dental education. If the money is withdrawn and not used for qualified education expenses, then the investments' gains are subject to ordinary income tax plus a 10 percent penalty.
What happens if the beneficiary receives a scholarship?
If the beneficiary receives a scholarship, then an amount equal to the scholarship may be withdrawn without penalty from the 529 account.
What happens if the beneficiary becomes disabled or dies?
If the beneficiary becomes disabled or dies, the money is refunded to the account owner without penalty.
What are those "qualifying education expenses" for which the money may be used?
Qualified education expenses include tuition, room and board, books and certain other fees and expenses.
Spreading the Wealth
Most dentists should consider setting up an employer-sponsored 529 plan through their practices for a number of reasons. Among them are:
- There is no cost to the dentist/employer to establish the plan.
- It is a great benefit to offer for all employees.
- For employees who elect to participate, it allows them the convenience of contributing to 529 accounts via payroll deduction or automatic withdrawals from checking accounts.
- With some states' plans, the expenses are reduced in the employer plan setting, so that even if the dentist/employer is the only individual electing to participate in the 529 plan, this may be the optimal way to structure it.
Sooner Than You Think
If you are interested in learning more about college funding, and about 529 plans in particular, there are several resources. Many financial planners are well versed in the intricacies of these plans and can help guide you through them. There is also a useful Website, www.savingforcollege.com, which has general information on college funding and 529 plans as well as links to the various state plans.
Saving money for college education expenses while also trying to accumulate money to fund one's retirement can be a daunting task. 529 plans, with their significant tax advantages, can help ease this burden.