It is no secret that college students today are graduating with unprecedented levels of student loan debt. According to Forbes, the total student loan debt currently sits at just over $1.3 trillion, with the average student from the Class of 2016 holding $37,172 of that debt. With no clear signs of tuition rates stabilizing in the near future, these numbers appear poised to only increase over time. While the current average annual tuition for a 4-year public, in-state university is $21,447 (CollegeBoard, College Cost Calculator), assuming a 5% annual tuition rate increase, the annual cost to attend the same university 18 years from now will be $51,615, with the cost of attending 4 years totaling over $222,000! (You can do your own projections here.)
Such a staggering figure is sure to evoke some strong emotions from soon-to-be or new parents, who may be paying off student loans themselves. After all, as much as parents and grandparents want to hope and believe their children and grandchildren will grow up to be stellar students or all-star athletes, the fact is the majority of students will have some level of tuition and various other expenses to pay for upon reaching college age. Following this realization, parents and grandparents should then ask themselves: What can I/we do to alleviate some of this burden? Fortunately, there are several options from which to choose in order to give children and grandchildren a head start. One of the best solutions for education saving is a 529 plan.
The issue of ever-increasing tuition rates has brought about a surge in popularity for 529 plans in recent years. These are tax-advantaged accounts in which individuals and families can invest in anticipation of future college expenses. While the contributions into the account are made after-tax, the earnings are typically tax-free, as long as the funds are ultimately used to pay for qualified college expenses. Additionally, some states offer a state income tax deduction for contributions to a 529 plan. If the funds are used for nonqualified expenses, the owner of the 529 plan will have to pay federal taxes on the earnings and a 10% penalty. However, if the beneficiary ends up receiving a scholarship, the owner of the plan can make a withdrawal up to the amount of the scholarship without paying the 10% penalty—the owner would only pay income taxes on the earnings.
Qualified expenses include items such as tuition, room and board, technology items (i.e. computers), and required textbooks and supplies. Most of these qualified expenses cannot exceed the estimates made by the school the 529 plan beneficiary will be attending. Nonqualified expenses include transportation, student loan repayment, and cell phone plans, among others. Thus, it is important to know which expenses are qualified and which are not before using the funds to pay for each item.
Parents and grandparents typically start one of these plans for their own children and grandchildren, but a 529 plan can be set up by anyone for anyone. People can start 529 plans for other friends and family or even for their own education. These plans also have no income restrictions and high contribution limits, with most plans allowing contributions of over $300,000. Also, any unused portion of a 529 plan can be transferred to another beneficiary, such as another child or a parent who decides to continue their own education.
There are some drawbacks to 529 plans, including investment choices that are limited to pre-established investment portfolios, penalties for withdrawals used for nonqualified expenses, and a requirement that all tuition credits be used before the beneficiary reaches age 30. However, in most cases, the benefits to the beneficiary of the plan outweigh the downside. Because every situation is unique, it is important to discuss each situation with a knowledgeable, trusted financial advisor who works closely with its clients to determine if a 529 plan is the most appropriate choice.