Just like having your first kid, setting up a 529 plan for the first time can seem overwhelming. With Nancy Mann Jackson’s help, you can avoid these five common mistakes.
Setting up a 529 plan to save for your children’s education can be an excellent idea. If you decide to set up a plan and save money toward your child’s college expenses, here are frequent mistakes to avoid.
Mistake #1: Assuming you must purchase your own state’s plan.
Just because your state offers a 529 plan doesn’t mean you have to use it. Each state’s plan is managed by a financial company that will do business with anybody who lives in any state. Instead of looking at the geographic location where the plan is based, look at the costs of the plan. “I’m in California, but our state’s plan offers no tax credit for residents who purchase it and it’s not the cheapest plan, so I don’t recommend it,” says Artie Green,CERTIFIED FINANCIAL PLANNER™ professional at Cognizant Wealth Advisors in Palo Alto.
However, it’s important to at least look at your state’s plan, as some states offer tax incentives for state residents who use their 529 plans. “Certainly we want the 529 plan to be competitive among all plans, but if your state offers some incentive by way of a tax deduction for contributions, it would be a mistake not to consider that benefit in your analysis,” adds Richard Carr,CERTIFIED FINANCIAL PLANNER™ professional with the Carr Financial Group in Worcester, Massachusetts.
Mistake #2: Not being aggressive enough.
Current rules allow parents (or others) to invest up to $70,000 in a 529 plan every five years. While it may not be possible to invest that much, “you should start with a high monthly contribution,” says Rick Kahler, CERTIFIED FINANCIAL PLANNER™ professional with Kahler Financial Group in Rapid City, South Dakota. “The goal is to get as much money in the plan as possible so it has lots of time to grow.”
Kahler recommends heavily investing in equities during the first 10 years of the child’s life, and moving to more bonds and cash equivalents as the child gets closer to college age. Many plans include a “target date fund,” which changes the types of investments automatically when the child reaches certain ages. But before you choose an age-based plan, carefully check out the plan’s history of success to ensure the plan manager is reliable. “Make sure the performance is at least average,” Kahler says.
Mistake #3: Taking too much money out of the plan in a given year.
Once the student starts college, pay close attention to how much money is withdrawn from the 529 in each calendar year. “Colleges charge expenses over an academic year,” says Joseph Orsolini, CERTIFIED FINANCIAL PLANNER™ professional with College Aid Planners, Inc. “Your tax return is reported on a calendar year. Sometimes people mistakenly take a full academic year’s worth of expenses from their 529, not realizing that half of those expenses will occur in the following tax year. This makes the excess distribution taxable in the current year.”
To avoid paying taxes on excess gains, take from the 529 only the amount that will match academic expenses for the calendar year, not the academic year, Orsolini says.
Mistake #4: Assuming that 529 funds will disqualify students from financial aid.
When your student completes an application for financial aid, he or she will be assigned a figure known as “expected family contribution (EFC), the amount of money that parents are expected to pay toward college expenses. The process considers earnings and assets held by the child, as well as earnings and assets of the parents. Some parents avoid socking away money in a 529 plan, “assuming that money accumulated in the plan will offset any potential financial aid award,” Carr says. As a “parent asset,” 529 funds are included in financial aid calculations, “but usually no more than 3 percent to 5 percent of the total is counted as ‘available’ to pay tuition,” Carr adds.
Because such a small portion of 529 funds is counted in determining the EFC, it is certainly worthwhile to continue building the fund. In some cases, transferring ownership to a grandparent can alleviate this concern. However, when funds are withdrawn from a 529 in a grandparent’s name to pay for college expenses, the students must then report those funds as income on the following year’s financial aid application, Green says. If this is an issue you’re concerned about, talk to an experienced financial planner. “There are a number of complex strategies for determining who should own the plan,” Green says.
Mistake #5: Paying all college expenses with the 529 fund.
There are tax credits available for paying college tuition, Orsolini says. So when families pay all college expenses with funds from a 529 plan, they miss out on educational tax credits. For example, the American Opportunity Credit provides a $2,500 tax credit for qualifying taxpayers who have $4,000 or more of qualified expenses. Qualified expenses include tuition and books.
“The government does not allow you to double dip on tax breaks,” Orsolini says. “Since you already got a tax break with the 529 funds, you cannot use expenses paid for with those funds to qualify for the tax credit. You need to use non-529 money for the $4,000 of expenses.”
Now that you know what to avoid, you’re prepared to make an informed decision about whether a 529 plan is the right savings vehicle for your children’s education.
What do you think, Grownups? Do you have a college fund plan for your little one (or little ones)? Whether you haven’t even given it a thought or if you’re already dreaming of graduation day at Harvard University, let us know about it in the comments section.
Freelance journalist Nancy Mann Jackson writes regularly about personal finance, small business, health care, and education. Her work has appeared in Entrepreneur, CNNMoney.com, Bankrate, Working Mother, and many other publications. She lives in Alabama with her husband and their three boys.
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