It’s April 15th, have you filed your tax return yet? If you are a last-minute filer like myself then you still have a chance to contribute to the 529 plan for 2010. The last day to file the 2010 individual income tax return is April 18, 2011. The last day to contribute to the 529 plan is either April 18th or the day you file your tax return.
As some of you know, we just had a baby and we want to save some money to help with his education down the line. My parents paid the bulk of my higher education expenses and I am extremely grateful for that. They believe higher education is the ticket to a better life and they worked really hard to pay for the college tuition and living costs. I don’t expect inheritance or anything else from them financially. If they have extra money, they should spend it and enjoy their retirement. I would like to do the same for our little guy as well so we contributed to my state’s 529 plan and will continue to do so as long as we can.
What is a 529 plan?
A 529 plan is a tax-advantaged investment vehicle to help parents save for higher education expenses. There are two types of 529 plans: prepaid and savings. The prepaid plan allows you to pay tuition at today’s rate to be used in the future. This type of plan is not offered in my state, so I didn’t consider it closely. It seems like it would be more worthwhile in a big state like California where they have a large network of very good public universities. The savings plan usually has a list of mutual funds you can invest in, similar to your 401k. The biggest advantage of the 529 plan is that the investments can grow tax free as long as you use it for higher education.
The money from the 529 plan can be used for tuition, books, supplies and other expenses for one beneficiary. The beneficiary can be anyone – your child, grandchild, or even yourself. If your beneficiary decided not to go to college, there are three options:
- You can keep the investment in 529 and let it grow tax free since there is no age restriction.
- You can change the beneficiary anytime as long as the new beneficiary is a family member of the current beneficiary.
- You can take a non-qualified withdrawal and the earnings will be taxed at the ordinary income tax rate. You will probably need to pay an additional 10% penalty unless you meet some IRS exceptions such as becoming disabled. I would do this only as a last resort since we can always transfer it to someone else in the family.
Advantages of the 529 plan
- Any earnings will grow tax free if you use them for higher education expenses.
- You can take a state tax deduction for some of your 529 plan contribution. In our state, we can deduct up to $4,180 on the 2010 state tax return. We pay 9% state income tax so this is a big incentive for us.
- We, not the beneficiary, retain control of the 529 account. This is good because I don’t know if I would trust an 18-year-old with a large amount of money.
- It’s easy to open an account and set up auto deduction. I went to set up our 529 plan in March and was able to contribute that same day. So you still have a bit of time if you haven’t filed your taxes yet!
- The 529 plan is counted as an asset when you apply for financial aid. The good thing is that the financial aid office only takes 5.64% of the 529 plan total value into consideration when they calculate Expected Family Contribution. If these investments are in a taxable account, then they would count 100% toward the EFC calculation. If the beneficiary is the owner of the account, then 20% of the 529 plan value is used to calculate EFC instead. I suppose he can try to claim independent status, but that is another difficult task.
- The 529 investments are not counted as the owner’s gross estate for estate tax purposes. So the 529 plan is a little bit of a tax shelter and can be used to stash future education expenses for your progeny.
Disadvantages of the 529 plan
If you invest in 401k then you will be familiar with similar 529 disadvantages. There are only a few mutual funds in each state’s 529 plan and you may not like any of them. Your state’s 529 plan maybe administered by a financial company that doesn’t perform well. Maybe your state does not have income tax so you can’t take advantage of the state tax deduction.
Contributions to the 529 plan are considered gifts by the IRS, so don’t contribute a huge amount in one year or there might be tax implication. The IRS also limits asset reallocation in the 529 plan to only once per year.
Personally, I think a 529 plan make sense for us because of our high state tax rate. If we lived in a state with no state tax, we would have to re-evaluate our contribution. It still has other considerable advantages, so we probably will keep contributing. As with any investment, it’s better to contribute $4,180 now rather than 10 years from now. I hope that investing early will give us a chance to compete with the rising college tuition. It might now pay the whole bill, but the 529 plan should help quite a bit.
Bonus point for anyone who can guess my alma mater below.