If anyone understands how difficult it is to start saving for a kid's college education, it's Tim Barnett, a wealth management advisor in Boulder, Colorado.
Seven years ago, Barnett and his wife had their fifth child. Considering his line of work, one might assume Barnett already had four college savings accounts in place and would be opening a fifth within days of the baby's birth. In fact, they hadn't started saving for college at all.
"My wife and I were in a big transition phase when we had our kids," says Barnett. "My business partner and I were starting this wealth management firm and, for a while, we needed our money to be liquid." The Barnetts knew they would eventually start saving.
When their youngest was born and their eldest was 6 years old, they opened 529 plans for each child. These plans, which are offered by most states and differ slightly from one state to the next, allow investments held within to grow tax-free, and withdrawals used to pay for qualified college expenses are not taxed, says Barnett.
Barnett's business partner, David McMillan, a certified financial planner and registered financial consultant, took a different tack when he and his wife had their first baby three years ago: "Within a month, we opened a 529 account for Felix," says McMillan. "Considering the cost of college is rising about twice the rate of inflation, it's important to think about as soon as you can. Time is your best asset when it comes to savings."
Here, Barnett and McMillan offer their professional and personal insights on things to consider when you're planning what to put away for junior's college education.
You read correctly. You can choose any state's 529 plan, says Barnett, regardless of where you live. "Conceptually, all 529 plans are similar, but some state's plans are better than others," says Barnett. For example, many states, including New York, Michigan, and Colorado, offer a state income tax deduction for contributions and some states have a cap on what you can contribute. And unless it's a rare prepaid college tuition plan, your child's college location isn't affected by the state your 529 plan is from. So, for instance, you might be a Georgia resident, invest in Illinois' plan, and send your child to college in California.
But each state's 529 differs in how your money is invested and what kind of tax benefit (if any) you might receive when you contribute. To figure out which 529 plan is best for you, check out Morningstar's 529 Plan Center, which McMillan calls the granddaddy of the investment universe when it comes to research, or go to savingforcollege.com, which is even more user-friendly for parents looking for the right plan, he says.
While it's tough to ballpark the kind of return you'll get on a 529 plan because they all hold different funds and investment allocations vary according to the individual, McMillan says you may see a return similar to what you're getting on your index mutual funds in your IRA or 401(k).
Barnett and McMillan agree they're lucky: Colorado happens to have a fantastic 529 plan, which allows state income tax deduction for contributions made to the plan by state residents. In fact, one of Barnett's California-based clients opened a Colorado plan. Here's where it gets interesting: Although this California resident isn't able to get the income tax benefit because he doesn't live in Colorado, he was able to hook up his relatives who are Colorado residents. "He made a gift to his relatives in Colorado with the understanding that they would deposit the money into the 529 plan," says Barnett. "Once they did that, they got the tax benefit."
Like any managed investment account, fees and expenses can add up over time and impact the investment performance, says Barnett. That's why it's important to pay attention to the costs associated with your plan. Every 529 savings plan discloses fees and expenses in the program disclosure statement, and Barnett advises researching and comparing those fees before making a decision. (For a comprehensive comparison, see Savingforcollege.com's semi-annual 529 Fee Study.)
Thinking about using a broker to help you figure out which funds to choose? The investment options within 529 plans may not be as complicated as you think. In fact they're comparable to and sometimes easier to understand than the average 401(k), says McMillan. "Normally there are only about a dozen or so options in a plan. Plus, there are pre-packaged choices that let you take a ‘set it and forget it' approach, where the allocation will adjust from being more growth orientated in the early years to more conservative as college nears," he says. Choosing an automated plan like that doesn't cost you anything extra and may be a good alternative to paying a broker, depending on your situation.
What if your kid decides not to go to college or gets a big scholarship? A 529 is still a great investment option because you can change the beneficiary to another family member–or to yourself, says Barnett, who notes that 529 plans can be used for vocational schools and other qualifying institutions. (American Academy of Dramatic Arts, Culinary Academy of Austin, Bel-Rea Institute of Animal Technology in Colorado and hundreds of institutions like these qualify. Search for eligible schools and learning institutions here.)
If your kid lands a scholarship, you can withdraw funds from a 529 plan equal to the scholarship amount without incurring the 10 percent penalty on earnings, which happens when withdrawals are used to pay for things not related to education expenses. (Note: You'll still have to pay income tax on the earnings in this case.) Even if you want to withdraw the savings for something other than higher education and pay the 10 percent penalty, you may still come out ahead given the amount of tax-deferred growth in your account. "It will still better than if you'd never have saved that money in the first place," says McMillan.
While Barnett and McMillan agree that in almost all cases, investing in a 529 plan is the smartest college savings vehicle, there are other options. A pre-paid tuition plan locks you in at today's tuition prices for many private colleges across the country. (Barnett says he doesn't recommend these, as they're "unattractive" if your kid decides not to go to a private school.) Other options include a custodial account, educational savings account, U.S. savings bonds, IRAs (Roth and traditional) and mutual funds held in an ordinary investment account.
Although it's best to save what you can, as early as you can, McMillan tells his clients they probably won't save enough to cover the entire cost of their kids' college education. McMillan and his wife, Wendy, are saving $300 a month, but they're already talking about the conversations they'll have with Felix when he gets older. This may include enticing him to study overseas for a couple years (where universities can cost about $10,000 a year) rather than only applying to four-year private institutions in this country.
"The bottom line is that even though Wendy and I are saving a decent amount, by the time my 3-year-old is 18, tuition could be around $100,000 a year," he says. "It's unlikely I'll be able to save close to half a million dollars in the next 15 years." When you think about it that way, McMillan notes, it's clear parents should not neglect retirement savings in a quest to pay for college down the road.
Also consider that any money saved for college will count against you in financial aid awards, whereas retirement assets won't. "Making contributions to retirement is particularly important if you have an employer-matched 401(k). That's free money you shouldn't turn down," says McMillan. Your college savings will affect how much you get in financial aid, but the flip side is that you may need to have money in a 529 for college costs, which means it doesn't make sense to shelter all of your savings in a retirement plan. "Because of the withdrawal penalties, chances are you're not going to be pulling from your 401(k) or IRA when college rolls around," says McMillan.
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