College affordability is tough but 529 college savings plans can help you boost college savings.
529s have similarities to Roth accounts. They are (mostly) taxed going in, but grow and get withdrawn tax-free (if spent on qualified things).
But 529s also have complexities, and the rules changed significantly with the Tax Cuts and Jobs Act and, more recently, the Secure Act.
So for this week’s podcast, I invited Ann Garcia, a CFP who specializes in (and blogs about) college financial planning, to deep dive on how 529 college savings plans work.
We talk about:
- Key rules, tax benefits, and pros & cons of 529s
- What are considered “qualified” educational expenses, how it’s enforced, and what happens if you fail to spend on qualified expenses
- When it makes sense to invest in a different state’s 529 plan vs. your own state’s
- Strategies and tradeoffs of grandparents funding 529s
- Important changes to 529s introduced by the Tax Cuts and Jobs Act and the Secure Act
- How the Private College 529 allows you to lock in future tuition using today’s prices
Do you have a 529 plan for your kiddos? Do you invest in an out-of-state 529 (if so, why)? Do you plan to roll into a Private College 529? What other 529 questions do you have? Let me know by leaving a comment.
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Links mentioned in this episode:
- College Financial Lady
- Independent Progressive Advisors
- savingforcollege.com -- for comparing different states’ 529s
- Private College 529
- Schedule a private 1:1 consultation with me
- HYW private Facebook community
Read this episode as a post:
My guest today is Ann Garcia. Ann is a Portland-based certified financial planner with a decade of experience as a fee-only financial advisor.
She is a member of the National Association of Personal Financial Advisors, and in her practice, she advises clients on how to navigate college funding and financial aid. And she writes frequently on these topics on her college financial planning blog.
I invited Ann to chat with us this week to deep dive on how 529 college savings plans work, how to select a 529 plan, strategies for how to best utilize them, and key tax rules to be aware of when it comes to 529 plans.
I’m excited because I think this will be a really practical and informative episode if you’re considering a 529 plan, and hopefully will help you think about 529s strategically in relation to the rest of your investment portfolio.
Ann, thanks so much for joining us today.
Ann Garcia 2:11
Thank you for having me.
Andrew Chen 2:12
I would love to start just by learning a little bit more about your background. How did you get into becoming an expert on college financial planning?
Ann Garcia 2:19
I have twins who are now college freshmen actually. And when I began as a financial advisor, they were a little earlier on in the educational process, and so this was something that I was personally interested in.
And I realized at the same time that 529s and college savings and paying for college in general were not topics that financial advisors were engaging in.
And the saying that people had about 529s, at least in the fee-only field, was people who were our clients aren’t really worried about how they’re going to pay for college.
And that to me just didn’t seem to address the reality of paying for college.
Paying for college is hard for most families. And if we as advisors are going to skip over the second largest expense that a family is likely to incur after retirement, then we’re really not serving our clients very well.
So it was equal parts personal and professional, my interest in it.
And I realized, as I started to do more research, that there was a huge knowledge gap between how college funding works and how college funding strategies are communicated to families.
Andrew Chen 3:37
All right. That’s really important to know because I think it is true that college expenses are very consequential to a family’s nest egg.
I’m also a new parent and I’m trying to learn this stuff as well. And I would say I’m pretty financially savvy, but it’s definitely something that I think many families could be better educated about to make better financial decisions.
So with that in mind, before we dive into the meat of it, can you give a quick summary, a 30-second summary of what is a 529 college savings plan, just to set the lay of the land?
Ann Garcia 4:15
Yeah, let’s do that.
A 529 college savings plan is a tax-advantaged college savings plan.
There are two really well-known tax benefits.
One is that a lot of states provide an upfront tax deduction or credit for your contribution.
And then the growth and distributions are tax-free as long as they’re used for qualified higher education expenses. So they’re a little bit like a Roth IRA where the money comes out as tax-free.
There’s a third advantage of 529 plans that’s much less known but that’s really consequential, and that is that this is the one savings account where your distributions that you take out of it are not reported on your taxes or on your FAFSA.
So when you take the money out, it doesn’t turn into income which would drive up your expected family contribution in either the FAFSA or the CSS Profile.
Andrew Chen 5:10
I see. Okay. I definitely want to get into that more in a moment.
What are the current contribution limits and, not state-specific tax rules, but at least generally how to think about it since it is a state level tax program? It doesn’t sound like you get a benefit at the federal level.
Ann Garcia 5:30
Correct. There’s no upfront benefit at the federal level. However, the growth and distributions are tax-free for federal tax purposes.
As far as contribution limits go, these are state-run plans, so the limits are set by the states, but they’re very high.
Typically, there isn’t so much a contribution limit as an account size limit. I think the lowest limit is in Georgia where the account limit is $235,000. But most states have $400,000 or more.
And that’s per beneficiary within the state’s plan. You could save a million dollars in 529 plans. You just have to choose a few different state plans to go in.
Again, at the state level, the states set limits on how much of your contribution is deductible or eligible for tax credit as the case may be.
Andrew Chen 6:25
I see. I’ve heard of this thing where you can accelerate five years of 529 funding in a single all upfront when you first open the account.
If there’s no contribution limit, what is the meaning of five years’ worth of 529 funding?
Ann Garcia 6:41
That’s a good question because it’s something that comes up and it’s really for a topic that’s fairly well-known. It’s a really meaty type of thing.
The accelerated funding is really a bigger benefit for grandparents who want to do college funding than for parents. For grandparents, it’s a way to remove assets from their estate because a 529 contribution is considered a completed gift.
So grandparents who want to get a million dollars out of their estate and have 10 grandkids could put $100,000 into each grandchild’s 529 account and not have to claim it as a gift.
You can contribute $15,000 annually per child per parent or per child per donee to a child’s 529 account.
So if two parents could do $30,000 a year, two grandparents could do $30,000 a year. And again, per child because the child is the beneficiary of that.
When parents do this, the downside is if you’re 30 years old, you’re not necessarily looking at how to remove assets from your estate.
When parents superfund, oftentimes they’re shooting themselves in the foot a little bit because many states do not allow you to carry forward excess contributions for state tax deduction purposes.
So if you’re sitting on $200,000 and want to get it into your 529, you can superfund, but you will lose the tax deduction in subsequent years in many states.
Andrew Chen 8:23
I see. So the super funding, I think $75,000 is the rule of thumb, but that’s at a $15,000 per year rate. It sounds like that’s conveniently in line with the no reporting required annual gift per donee.
Ann Garcia 8:44
Correct. Superfunding is more of an estate planning strategy than a college funding strategy in most cases because most parents don’t have a spare $75,000 sitting around once their child is born.
Andrew Chen 8:57
Gotcha. But since now the estate tax exemption limit is $11 million and more per taxpayer, you could just fund the whole thing all upfront.
Maybe you don’t get the state tax benefit. Let’s set that aside for a moment.
But if you put $100,000 or $400,000 in a 529, there would still be no tax, would there be? I guess there would be a transfer tax, right?
Ann Garcia 9:28
There would be a transfer tax, but you would have to file a gift tax return.
Andrew Chen 9:32
Would there be tax liability?
Ann Garcia 9:34
No, there’s no tax liability. You’re just taking against your lifetime estate exemption.
So again, superfunding is much more an estate planning strategy than a college funding strategy.
Two parents could each do $75,000 into a child’s 529. That would be $150,000 upfront. And you might be done with your college funding at that point.
Andrew Chen 10:00
I see. So staying under that $15,000 per year limit or superfunding $75,000 and then taking a pause for five years, that just allows you to not have to file the gift tax form.
Ann Garcia 10:13
Andrew Chen 10:14
But either way, whether you’re above or below that amount, there’s no actual tax liability as long as you’re still under the very high amount of the $11 million per taxpayer estate tax exemption.
Ann Garcia 10:25
Andrew Chen 10:26
Gotcha. Okay, cool.
So, I would love to talk a little bit about when it comes to distributions from the account, what are considered qualified educational expenses? And what happens if you neglect to or fail to use 529 money on qualified educational expenses?
Ann Garcia 10:46
Qualified expenses is one of those crazy topics where every single thing that applies to qualified expenses has a slightly different rule. So this is strictly for 529 purposes. It’s not for tax credits.
Tuition, any required fees, room and board, and books are the college years’ expenses.
So if you attend college out of state, you can’t use your 529 for air travel to get there. You can’t use it for a car.
But you can use it for a computer. You can use it for internet access.
Some other things you can use it for.
A high school student taking dual credit classes can use 529 to pay for the dual credit enrollment. There are some gap year programs that let you use it.
And then with the two recent tax law changes that probably warrant their own discussion, 2018’s TCJA and then the Secure Act, they’ve expanded the use of 529 plans.
If you take a non-qualified distribution, and there are several reasons that you might do that, one might be you take out more than you were supposed to, or you use the 529 money for other stuff.
That’s what’s called a non-qualified distribution. In that case, you pay a 10% penalty and you pay income tax on the gain portion of the non-qualified expense.
So let’s say you put $2000 into your 529. It grew to $4000. You have $4000 of gain.
You do a non-qualified distribution of all $4000. You would pay the tax and the 10% penalty on that $2000 that’s gain.
And then some states will impose what’s called a clawback of estate tax deduction that you took upfront for it.
Andrew Chen 12:46
I was just curious. How is that tracked and enforced?
Ann Garcia 12:50
That’s a good question too.
The way that the IRS monitors this is that when you’re in college, your college issues you a form called a 1098-T, which is a tuition statement. That only includes your tuition, so it’s not all of the possible qualified expenses.
But then your 529 will give you a 1099 for the distribution that you took.
Basically, the IRS wants to see that there’s a matching social security number for the 1098-T and the 1099. And as long as that’s the case, it’s pretty much end of discussion.
If, however, the 529 distribution is vastly out of line with the 1098-T, and vastly out of line because the 1098-T is not going to include your room and board, it’s not going to include your books, it’s not going to include any of those other things, then you might be subject to an audit, in which case, you’d have to produce all your receipts for room and board, for books, for all the other things that you’re claiming against your 529.
Andrew Chen 13:53
Got it. So I guess it’s a best practice that one should keep their receipts from the co-op, etc.
Ann Garcia 13:59
Yes. Good luck with a 19-year-old on that.
Andrew Chen 14:06
But when you say if it’s vastly different, and the 1098-T only contains your tuition bill, it could be, right? Because when you factor in room and board alone, that could be five figures above and beyond the tuition bill.
Then you factor in books, and if there are other qualified expenses, like fees or school-related expenses that are not on the 1098-T, the gap might be 50% more than the 1098-T reflects.
So what’s considered vastly different?
Ann Garcia 14:41
I would say more than double in most cases. So you just need to be able to make a reasonable case.
And the fact of the matter is most people do not have hundreds of thousands of dollars in their 529 accounts. Most people are taking out less than their actual expenses, and some of their college funding is coming through cash flow or through borrowing. So this is not an issue for the vast majority of people.
Where you typically see a non-qualified expense that gets challenged is a kid who ended up not going to college and wants to take the money out, or scholarships were granted and the 529 was overfunded, or people taking a distribution from their 529 in a different year than they’re paying their bills.
Andrew Chen 15:39
I see. Can you say more about the last one? When would that last scenario occur?
Ann Garcia 15:44
That last scenario occurs when you’re billed for your tuition at the end of the year and school happens in the subsequent year.
Your 1098-T can either report amounts that are paid or amounts that are billed in the year.
And so the law changed a few years ago to allow you to take a distribution in December for your spring quarter’s tuition because if your school started the Monday after New Year’s, you have to pay for it probably in the preceding year.
That’s all been simplified, so it’s less penalizing for parents who have to make that tuition payment the first day of January or before the first day of January.
Andrew Chen 16:44
Is that because schools allow you to pay it after the 1st of the year? Or how does it simplify exactly?
Ann Garcia 16:52
It used to be that you could only take a 529 distribution in the year that the expense was due.
Students are on quarters. Winter quarter will typically start right after New Year’s and your bill is due right before school starts, which basically means many people would pay it in December or take the distribution from their 529 plan in December so that it would be in their checking account in January when they have to make that bill.
So that got rectified a few years ago where you can now take a distribution in December to pay for winter quarter tuition.
Andrew Chen 17:33
I see. Does that also solve the issue of, in your freshman year, you’re only going to be in school for that calendar year for a few months, and then in your senior year, you’re only going to be in school for a few months in the spring? Does that solve both of those scenarios as well?
Ann Garcia 17:53
It addresses those. And one of the things with funding planning is there’s a portion of it that’s based on tax years.
But four school years is going to run you into five tax years. And so that can cause some issues, not so much 529-related as tax credit-related and whatnot, where you have for tax years to divide over five school years.
Andrew Chen 18:19
Earlier, you mentioned some of the changes with the Tax Cuts and Jobs Act that went into effect in 2018, Secure Act that went into effect in 2019, toward the end of the year. Can you comment a little bit more on what some of those changes were?
Ann Garcia 18:33
The TCJA is probably more significant for most families because that allows parents to use a 529 for K-12 expenses.
There’s two really important points about that.
One is that not all states have gone along with those changes. I think 13 states have not conformed to the TCJA provisions on 529s.
And so parents using their 529 in those states for K-12 expenses will be subject to state level penalties. And so that’s state tax that could be clawed back of state tax deduction.
And in California, there’s actually a 2.5% penalty for a non-qualified distribution from a 529 plan.
Andrew Chen 19:30
K-12 is included as one of those?
Ann Garcia 19:33
Correct, because those 13 states did not go along with the Tax Cuts and Jobs Act allowing use of a 529 for K-12 expenses.
Thirteen states. Well, there’s 50. So what are the odds?
Well, the odds are pretty good because California, Illinois, New York, many of the bigger states didn’t go along with those. Oregon, my state, as well.
The other really important point is that parents who are thinking about using their 529s for non-college expenses really need to be careful that they’re not leaving college underfunded.
It may seem like a great idea at the time, but college is going to be expensive, and so you need to be prepared for that expense as well.
My advice to people who think they might use a 529 for K-12 expenses is use an out-of-state plan and have a separate account that’s for K-12. If there’s any surplus in that, obviously, you can use it for college as well.
The Secure Act expanded use of 529s for apprenticeships and then to pay back student loans.
I think the apprenticeships piece is far more significant. Hopefully, that relieves some of the anxiety from parents of younger children where you can get the most bang for the buck in funding a 529.
A lot of parents say, “Well, I don’t know if my kid is going to go to college. Is this really something I should do?”
Expanding that to apprenticeships is a good thing.
For student loans, I’m not really sure that there’s a whole lot of value there. It would be unusual to have student loans and unspent 529 money.
So unless you’re trying to do what we call a tax deduction wash where you contribute to your 529 to get a tax break and then take the money out right away to pay student loans, I’m not sure what the real advantage or how many people are going to find this to be advantageous.
If that’s your strategy, you’ll want to check with your plan to make sure you meet any required holding period to get the tax breaks.
Many plans, for example, require that if you’re taking the tax deduction, the funds need to be in the account on December 31st of the tax year for which you’re taking the deduction.
Andrew Chen 21:53
Got it. On the student loan piece, I think you mentioned a moment ago that when the money comes out of a 529, it’s not reportable to FAFSA.
So that money is not counted as income to the child when it comes time to calculate their expected family contribution for FAFSA. Is it true also for the profile schools?
Ann Garcia 22:23
Andrew Chen 22:26
I see. And it’s not counted as an asset either?
Ann Garcia 22:30
It is counted as an asset. But assets are a far less significant piece of the expected family contribution.
Income is 50 cents on the dollar. It will increase your expected family contribution. Assets are five cents on the dollar.
Andrew Chen 22:46
Gotcha. So a parental 529 is counted as an asset at 5%, but distributions from it are not reportable to FAFSA and, in theory, should not be counted toward your EFC for the CSS profile schools as well?
Ann Garcia 23:02
Andrew Chen 23:03
Also a moment ago, you mentioned that if you are thinking about using 529 funds for K-12 but you live in a state that doesn’t conform to that provision – for example, in California, that even penalizes it – let’s say I’m in California and I wanted to use 529 money for K-12. If I open a 529 in another state that allows for this use, does California care about it?
Does it say, “Well, you opened a 529 in State X, but you’re in California, so no tax break and penalty”?
Or does California not have any reach into that 529 because it’s not their own?
Ann Garcia 23:51
They’ll still see it because when you take the distribution, you’ll get a 1099 from it.
For example, in Oregon where I am, we get a state tax deduction. Actually, they changed it to state tax credit and also don’t conform to that provision of the TCJA.
So if I took a distribution from my Oregon 529 to pay for K-12 education, I would be subject not only to state income tax on that distribution, but also a clawback on the tax deduction that they gave me for my contribution. So if I were using an out-of-state plan, then I’d just be subject to state income tax.
And it may be that if I had enough assets that had grown enough, that I would be better off using a 529 in that case, just to have the tax-free growth, even though I’m paying state income tax on my distribution.
In California, the calculus is different because you’re penalized in addition. There’s the tax plus the penalty.
Andrew Chen 24:58
And that would be true even if I had a special 529 from a different state specifically to fund K-12? California will still see through that and penalize you at 2.5%?
Ann Garcia 25:10
Correct, because you won’t have a 1098-T to match with the 1099 you get for taking the distribution.
Andrew Chen 25:20
Ann Garcia 25:21
And you will have claimed your 13-year-old as a dependent on your tax return.
Andrew Chen 25:28
Is there no way around that for somebody who is, for example, in California and they want to use the money for K-12?
Ann Garcia 25:36
Nope. There’s no way around it other than cheating.
Andrew Chen 25:41
Which you should not do!
Ann Garcia 25:42
Exactly. In that case, you’re really better off using a taxable account, or using, if you’re eligible, a Coverdell ESA. I don’t think anybody in California is eligible for a Coverdell because of the income limits for contributions there.
Andrew Chen 26:00
Got it. What are some of the considerations that parents should be evaluating when deciding whether to invest in a 529 in the first place or put those monies in some other account?
So, a family has limited dollars to contribute across all the different retirement and tax-advantaged accounts: 401(k)’s, IRAs, Roths, HSAs, etc. 529s is one of them. How should they be thinking about 529s in relation to those?
And what would your advice be in terms of the stack rank of those accounts? If you had to cascade your limited dollars down, where would 529 fall in that priority?
Ann Garcia 26:37
That’s a really good question, and it doesn’t have an easy answer other than our easy answer on all investments: Liquidity comes first than investments.
Do you have adequate liquid emergency savings? And if so, then you can start saving for retirement.
If you have adequate liquid emergency savings and retirement savings and you can carve out $20 a month out of your budget, then it’s time to start a 529.
But liquid savings and retirement savings should come first.
All that being said, college funding really needs to not be the redheaded stepchild.
A lot of people are under the false impression that not saving for college means you’re going to get more financial aid. And in fact, not saving for college just means you’re going to take out more student loans or have a far more limited scope of choices for you for college.
So college savings needs to be on parents’ radar screen.
And in particular, there’s a body of research that shows that, at every income level, students with at least some college savings, even really small amounts, enroll and complete college at much higher rates than those who don’t.
So you are really giving your kid a leg up on college even if you’re putting $100 a year into a 529.
Andrew Chen 28:02
Gotcha. With that in mind, what are some of the key factors that parents should be considering when choosing among various 529 plans? There are, as I understand, many options.
Ann Garcia 28:15
Yeah, there are a lot of options.
I always think you should start by researching your state’s plan. If your state offers a tax benefit, then that should be your starting point.
At a minimum, you should contribute enough to get your full state tax benefit, because if you’re in a state like Oregon or California, that’s a high tax state.
In Oregon, our tax rate is 9% or 9.9%, so you’d get a 9% or 9.9% return on your initial contributions because of the state tax benefit.
If you don’t have a state tax benefit, then look for a low cost plan with good investment choices, like Utah.
savingforcollege.com is a great resource for researching 529 plans. They break them all down by state and have a lot of good data and comparison tools there.
When it comes to your previous question about 529s versus retirement savings, we see a lot of families falling into one of two traps.
One is they underfund retirement because they want to have money available for college. And two is they underfund college on the assumption that it will get them more financial aid.
Neither of those is a really good strategy. And there isn’t one good answer to how everyone should make that decision because it really varies so much based on your circumstances.
For a family with four kids, it’s going to be a different answer than for a family with one. For parents who are 50, it’s going to be different than for parents who are 30.
Andrew Chen 30:03
Definitely. Are 529 plans exclusively administered by state governments so that there’s only one offered per state? Or is there also a private market with more options?
Ann Garcia 30:15
529 plans are primarily administered by state governments. Most states have one.
Some states also have what’s called an advisor-sold plan, and those have tools that advisors can use. They are generally not your best choice because they charge fees that then are credited back to the advisors.
You can invest in more than one. You’re not limited to your own states. So even though they are offered by states, it’s not required that you invest in your own states.
Another good 529 option is what’s called the Private College 529.
And I’m going to give them a plug here because what’s nice about that Private College 529 is they are a great inflation hedge for a portion of your 529 budget, even if you don’t attend private school.
What they will do is they give you what’s called tuition credits. So it works like a prepaid plan.
You buy in at today’s rate for whatever private college member school you end up attending. And if you don’t end up attending one of those member schools, you just get the average inflation rate.
My daughter attends a private school, the University of Chicago. And when she was accepted last year, I made a contribution to Private College 529 that we’re going to use for her senior year because you have to leave the money in there for three years.
So we bought some senior year tuition at the cost of tuition her senior year of high school because every year they just increase it. It’s a tuition credit plan.
Now, if I had put just regular money, if I had put money in there that was not being used at a private school, I would get the average inflation rate across all of the schools, which has historically been about 3%.
So that’s still a pretty good return when you compare it to a short term bond fund that you’ll get in your state’s 529.
In my daughter’s case, her school tuition has gone up by about 5% or 6% every year, so I’m guaranteed that my dollars will keep pace with inflation in her account.
So that’s one option out there that might make sense for a small portion of yours, but the vast majority of plans are state-based. And there’s no limit on how many different state plans you can contribute to.
Andrew Chen 32:57
Got it. I want to circle back to the Private College 529 here in a moment.
But just to close out the state 529 discussion, are there any other considerations where it would make sense to invest in a state-sponsored 529 that is not from your own state?
Ann Garcia 33:16
If your state doesn’t offer a tax deduction or any kind of tax benefit for your contributions, then you want to look at other states and just pick the one that has the lowest cost and the best investment options.
I think California doesn’t offer a tax deduction, and so there’s no benefit to you of investing in the California plan compared with, say, Utah or Nevada.
Utah and Nevada have great investment options with Vanguard funds. You have multiple age-based strategies at every age. And there’s no incremental benefit to that.
Even if you’re in a state that offers a deduction, if you’re contributing more than the deductible amount, then it’s also worth shopping around and seeing if there’s a better option for those non-tax preferred dollars that you’re putting in.
Andrew Chen 34:15
Got it. And it sounds like, you were saying, for researching 529 plans side by side, you’d recommend savingforcollege.com?
Ann Garcia 34:23
Andrew Chen 34:25
Got it. So back to the Private College 529, I’m just so curious about that.
You mentioned the example of your daughter at the University of Chicago. Does that mean for her senior year’s tuition, you basically prepaid at current rates?
So you essentially lock in that amount and that is the price even four years from now? Is that correct?
Ann Garcia 34:46
Correct. It’s a prepaid tuition plan.
Most 529s are just based on account value. They’re a small number of what’s called prepaid tuition plans. In this case, the institutions are guaranteeing the rate of return in the plan.
Andrew Chen 35:09
University of Chicago is in this scenario?
Ann Garcia 35:12
Yeah, exactly, for my daughter who’s a student there.
If she was attending a different school that was a member of the Private College 529, then she would get that school’s rate of inflation.
But we effectively prepaid tuition based on the 2018-2019 tuition rates. And we’ll use that money her senior year. And the reason we use it for senior year is that they require you to keep the funds in the plan for three years.
Most of her likely college scenarios were public schools, so we didn’t see a need to fund it until we ended up committing to a private school that was a member of the Private College 529.
Andrew Chen 36:00
I see. So Private College 529 only applies to private schools, not public schools.
And they have to be members of this group. Is that right?
Ann Garcia 36:10
There are 300 member schools in the Private College 529.
If you open an account in the Private College 529 and then go to one of those member schools, you have bought prepaid tuition at that school. So you’re buying tuition credits at 2020 rates that you’re then redeeming for future tuition.
If you don’t go to one of those schools, then your account growth is based on the average inflation rate of those schools’ tuition. And so you can either roll it out to another 529 at future value or just take a distribution and use it to pay for other schools.
One other thing about the Private College 529s. State-based 529 plans, you can use for tuition, room and board, books, required fees, graduate school, etc.
Private College 529 is only for undergraduate tuition.
Andrew Chen 37:20
Oh, I see. It cannot be used for room and board and fees and things like that.
Ann Garcia 37:24
Correct. It’s only tuition and only for undergraduates.
Andrew Chen 37:29
Gotcha. Why do schools do this? Let’s say at the University Chicago, I think you said the average increase per year is something like 6%.
Ann Garcia 37:45
Why would they guarantee me that?
Andrew Chen 37:48
Yeah. It’s not so easy to consistently beat 6% every year investing on your own. So what’s in it for them?
Ann Garcia 38:00
Typical endowment returns, which private colleges tend to have, generally exceed typical tuition inflation. And so this is effectively backed by their endowments.
Why would they do it? They’re earning the spread on those dollars.
Andrew Chen 38:35
So the money that you prepaid, though, sits in the account. It doesn’t go to the University of Chicago on day one, does it?
Ann Garcia 38:40
No, it doesn’t.
Andrew Chen 38:42
Okay. I see.
Ann Garcia 38:44
Because you basically have to start investing in it before your student is enrolled there because of that three-year holding period.
Andrew Chen 38:54
If I have a five-year-old, can I start doing this? Can I just buy in today’s tuition rates for tuition that’s going to occur in 13 years?
Ann Garcia 39:05
Yeah, you absolutely can.
And as an investment advisor, to me, this is better than having TIPS in your portfolio because you’re getting the average inflation rate across colleges.
And when you look at where tuition growth has been the highest, it’s been in the years when parents can least afford tuition increases.
So this is definitely a good hedging strategy for your 529 portfolio.
Andrew Chen 39:43
Okay. So in terms of the mechanics, just so I understand this.
Let’s say I have a five-year-old and I aspire for her to go to one of the 300 member schools, so I’d prepay $50,000 or something right now.
Because I don’t know exactly which school she may enroll in, you would put in a best guess. How do you decide the amount? Or is it just like how you would decide with any other 529?
Ann Garcia 40:14
It’s how you would decide any other 529.
Again, I see it more as an inflation hedge when you’re looking at your close to college dollars. I’m not sure I would put money in there for a very young child because your regular 529 in an age-based plan for a one-year-old is going to be 90% stock.
Andrew Chen 40:42
Yeah. Over the long run, that’s probably going to perform better.
Ann Garcia 40:44
Over the long run, that’s going to outperform as you get closer to college and that’s tilting more towards fixed income, having that guaranteed 3% return. But you’ll get through the average inflation rate of these colleges.
That can be a nice hedge to have in your portfolio where, even if you don’t go to a private school, having guaranteed 3% growth in a portion of your portfolio, regardless of what the stock market and the bond market do, can be a good thing.
And if you end up in one of these schools, chances are you will have more than 3% growth in your account.
Andrew Chen 41:35
I see. So if I put money into a Private College 529, do I invest in index funds like I would in any other 529, and it just grows and grows?
And then when it comes time to go to college, if I’m in one of those member schools, then I’d go back and look up what was the tuition rate at the time that I contributed, and that’s the price that I pay? Is that how it works?
Ann Garcia 41:58
Unlike a normal 529 where you’re going to choose an investment option, whether it’s an age-based or assemble your own portfolio, in the Private College 529, you just are putting dollars in.
So let’s say you put $5000 in. They’ll ask you if you want to identify a couple of schools that you’re interested in.
Let’s say, since we’re talking about University of Chicago, I put University of Chicago in as the school that we were interested in. I put in my dollar amount and they said, “You have bought x% of one year of tuition at the University of Chicago.”
If I put in a different school, it would give me a different number because every school’s tuition is different.
So I know that I have a certain portion of my daughter’s senior year tuition paid. And if I had started contributing younger, I could have different years’ tuition paid. But I chose to wait until we knew where she was going.
Andrew Chen 43:00
I see. So what is the best strategy for utilizing a Private College 529, assuming your kid is going to go to a private college?
Is it that you invest normally in a regular 529, and then as you get closer to college enrolment, then you somehow roll it or convert it into a Private College 529 and lock in the tuition rates at that time?
What’s the basic strategy that you advise your clients?
Ann Garcia 43:25
My advice with the Private College 529, because it’s a prepaid tuition plan, is when you’re young, you want the market exposure that a regular 529 plan gives you. It’s a good hedge for some of those dollars as you get closer to college and have a better sense of what your kid is going to be doing.
So the bulk of your money should be in a regular 529, particularly at younger ages, to get that growth, and also because there’s limits to what you can use the Private College 529 for.
And then as you get closer to college, because it’s more like an insurance contract than an investment, as you get closer to college, it can make sense for a portion of your portfolio.
Andrew Chen 44:19
So the mechanics of doing that is you would then, at that point, open a Private College 529 and roll some money into it? Is that accurate?
Ann Garcia 44:28
Yeah. You can roll money from an existing 529. But again, if you’ve taken a state tax deduction on that money, you may have a state tax clawback on that rollover.
Or you can simply put new money into that account.
Andrew Chen 44:43
Oh. Is that considered a distribution, not a non-taxable rollover?
Ann Garcia 44:49
Anytime that you have taken a tax deduction for your 529 plan contribution and you use it for something other than a qualified education expense, for example, you roll it over to another state’s plan, you can be subject to a clawback on the state tax deduction.
That’s a state by state rule. So just something to think about.
But again, when you do that rollover, you’re going to get a 1099 from the plan. And so you do have to report it.
Andrew Chen 45:22
I see. So it may be considered a taxable distribution, but you really need to check at your state level.
Ann Garcia 45:28
Not a taxable distribution, but a clawback of your state tax deduction that you took for the contribution. So your normal taxable distribution is tax on the gain.
Andrew Chen 45:40
Ann Garcia 45:41
If you took a state tax deduction for your contribution, that’s what would be subject to the clawback.
Andrew Chen 45:47
Okay. Thank you for the clarification. So it will not trigger a tax liability on any gain, but you may have to pay back any deduction you took.
Ann Garcia 45:55
Andrew Chen 45:57
They don’t make this easy, huh?
Ann Garcia 46:00
Andrew Chen 46:02
I feel like I’m learning a whole bunch here too. I’m taking notes.
Ann Garcia 46:08
And I know that Private College 529 is a little bit of a side topic, but it’s something that I learned about late in the game and I thought, “Oh my gosh. This is fantastic.”
I wish more people knew about it for a portion of your 529 money.
Andrew Chen 46:26
Yeah. I didn’t know about that either.
So I’m just trying to tease out. If I really wanted to be efficient with my dollars for saving for my kids’ education, then it sounds like I would, in the early years when my child is young, put all the money into a regular 529. Get market exposure for that.
And as she gets closer to college, either fund with new dollars or make a calculated decision on rolling money over from a regular 529 into a Private College 529, assuming she is going to attend a private school.
And use the private 529 for the tuition portion for undergrad. And maybe use the regular 529 for other expenses, like figuring out what’s the right strategic combination. Is that correct?
Ann Garcia 47:16
That’s correct. And it would be so much easier if we knew, when our kids were born, where they were going to go to college because we could do all this stuff exactly right.
Andrew Chen 47:27
Right. What are the some of the types of investment options you typically find in 529s compared to what you find in a 401(k) or an IRA?
Ann Garcia 47:36
529 investment choices are really similar to 401(k)’s. There’s a set investment menu. There’s no brokerage window.
An IRA, you can invest in anything you want to. But a 401(k), you’re given a limited suite of investment choices.
Most state-run 529 plans offer basically the 529 equivalent of a target date fund, which is an age-based plan.
Some will offer aggressive, moderate, and conservative within that window, and then offer individual funds that you can invest some or all of your account in. So it’s very much like a 401(k).
The thing that’s important to remember with investment options in 529s compared with 401(k)’s is if you choose a target date fund in your 401(k), you’re looking at something that’s going to gradually ratchet from aggressive to conservative over, say, a 40-year time horizon.
In a 529, it’s going to ratchet from aggressive to conservative over 18 years. You’re going to go from all stock to all cash and fixed income in 18 years.
And so when you go with an age-based investment, if you wait until your child is seven or eight or nine or 10 years old to start investing, you’re already going to be pretty conservative.
And so that’s why “save early and save often” is the best advice for that.
Andrew Chen 49:03
All right. Good tip there.
One strategy that some parents use is to have grandparents open and fund a 529 for their grandkids. And that has the benefit of those funds not being listed as an asset on the FAFSA form for purposes of calculating your expected family contribution.
And I was just curious to get your perspective. Do you recommend that strategy? And what are the considerations and downsides, if any?
Ann Garcia 49:32
I think it’s great when someone wants to help. You should never say no.
And there’s two ways for grandparents to help.
One is having a 529 that the child is named as the beneficiary.
The main downside of that is if it’s used before January of sophomore year in college, the distribution gets reported as student income on the FAFSA and on the profile.
So 529 money from a grandparent is best held until sophomore year.
Another strategy that’s really good for grandparents is to use a Roth IRA. Whether they do Roth conversions into a dedicated account that’s for the grandchild or something else, that’s great.
What the grandparent can do then is they can take a distribution from the Roth IRA, gift it to the parents after the FAFSA has been filed, and then the parents use that to pay for the expenses, because gifts are the other thing that don’t get reported on the FAFSA.
Other advantage of using a Roth IRA for a grandparent is that they can use the money to pay for things like travel. If they want to pay for their student to join a sorority or fraternity, they can use it for that.
So there’s no restrictions on what Roth IRA money gets spent on compared with a 529 that needs to be spent on qualified higher education expenses.
The other thing to keep in mind with grandparent 529s is the CSS Profile is different from the FAFSA in that the FAFSA has one set of questions, one calculation methodology.
On the profile, schools can add their own questions. And one that’s added in virtually 100% of profile schools is “Is anyone else saving for college for you?”
So if your grandparents have a 529, you do report it as an asset on the profile.
Andrew Chen 51:40
I see. So it is taken into consideration in the EFC calculation for profile schools.
Ann Garcia 51:47
Andrew Chen 51:49
Interesting. You mentioned a moment ago that one option that may be better for grandparents is to simply use money from a Roth account to help the grandkid with education-related expenses.
I’m just wondering. Are there any risks associated with that?
Because if the grandparents are retired, other than Roth conversions, there’s no way to get more money into a Roth. You would have to have earned income.
And if they don’t have money that they could convert, then any money that they take out is finite.
Roth has the advantage of not having an RMD and it’s tax-free on withdrawal. So to fund their own retirement, it’s valuable.
I’m just trying to get a sense of what are the considerations of using a Roth for grandkid expenses versus for your own retirement.
Ann Garcia 52:46
One of the big advantages for a retired person doing Roth conversions and saying, “This is money I would like to use for my grandchildren for college” versus putting it in a 529 is, should their circumstances change and they need that money back, if it’s a Roth IRA, nobody else has any claim on it.
A 529 is a completed gift to the student.
Now, the grandparent could go and take the money out, take a distribution, and use it for themselves, but they would pay tax and penalty on that distribution.
So doing a Roth conversion rather than spending a 529, it keeps some control of it with the grandparents and allows them to keep that money for themselves should they need to do so.
I would think that any grandparent who’s thinking of helping their grandkids with college should do two things.
One is have a conversation with the parents to let them know that that is their intention.
And the second thing is to have a conversation with a financial advisor to make sure that they’re not putting their own retirement at risk.
It’s wonderful to help, but not when that help results in the grandparents moving in with the parents 20 years later because they’ve run out of money.
Andrew Chen 54:01
So, let’s say you’ve saved up for a 529 for your kid. You have a lot of potential funds you could use there. And then your kid wins a full scholarship, or they, for whatever reason, decide that college isn’t for them.
Now you have a bunch of money in your 529, or the grandparents do. There are penalties associated with not using the money for qualified educational expenses.
What are some options that account holders have at that point to try to avoid penalties or avoid that kind of payback?
Ann Garcia 54:46
There’s a few things people can do.
First and foremost is, if grad school is part of their path, you can certainly save the 529 dollars for grad school.
You can also change the beneficiary to someone else.
So if you open a 529 for the first grandkid and they don’t use it, just change the beneficiary to the second grandkid. Or leave it where it is, and once they have kids, change the beneficiary to their kids.
You could also distribute it out to the student, in which case, it’s taxed at their lower tax rate.
And you don’t have to take all the distribution in one year.
Let’s say the student is in the 0% or 12% tax bracket. 0% tax rate is 0% tax rate. They pay a 10% penalty on the game, but they’re still coming out quite a ways ahead.
I recently had a client I was working with, and their son decided not to go to college but needed to buy a car for his job. And so they distributed his 529 money out to him so that he could buy a car.
And it saved him a lot of money on a car loan, interest expenses, all that kind of stuff. He was in a very low tax bracket, so he paid virtually nothing on that distribution.
And then they spread it out, did half in 2019 and half in 2020 to further mitigate the tax consequences of doing it.
But the main strategy that people use is just change the beneficiary to someone else or save it for grad school.
Andrew Chen 56:31
One thing I also wanted to get your perspective on is that there are some folks in the retirement/financial advisory community who might say a 529 actually is not the right choice for everyone.
Because if you just put the same money in a 401(k) or a Roth IRA or an IRA, those are retirement accounts.
It does not ever get reported to FAFSA. It’s not included in your EFC contribution. Much more flexible in how you spend those dollars because it’s not restricted to education expenses.
And just like you mentioned earlier with the grandparents scenario, you could use it for retirement or you could use it for education.
If your kid wins a scholarship, there’s no 10% penalty because you could just divert those dollars elsewhere.
How would you address folks who have that sort of skepticism when it comes to 529s?
One thing I also wanted to mention is that the investment options, not always, but typically are going to be more expensive in a 529 plan in terms of the expense ratios, even for the exact same type of passive index funds.
So for those who have that sort of reluctance, or at least concerns, what would be your response to that?
Ann Garcia 57:48
Those are a lot of things. Let me separate it into a few things.
First of all, saving is good. Never criticize yourself for choosing between saving for retirement and saving for college.
It’s great to save for both. It’s good to save for either. So saving is good.
Let’s talk first about saving in a 529 versus just buying low cost mutual funds.
Because it is correct that 529 plans have higher expense ratios for the same funds than taxable accounts. I think this speaks really well to how we think about taxes, which is we complain about them, but we don’t think about them.
Let’s say your 529 plan has an expense ratio of 60 basis points and you could invest in Vanguard Total Stock Market ETF in a taxable account for five basis points.
VTI, which is Vanguard Total Stock Market, has a 2% dividend yield.
Just for the sake of easy math, let’s say you were going to invest $10,000 when your child was born in one or the other. So your $10,000 in VTI with a 2% dividend yield is going to yield $200 in taxable income the first year.
Let’s say if you had $10,000 to save for college, that you’re at least in the 22% federal income tax bracket, plus you pay state income taxes.
So that $200 in taxable income is going to cost you $60 in taxes that year, which is the equivalent of 60 basis points.
That’s before we even talk about whether you’ve got a state tax deduction upfront for this.
Then going forward, let’s say Total Stock Market does a great investment for your one-year-old, but by the time you’re 18, you want to be in a lot of fixed income.
So you’re going to have to sell that in your taxable account and realize capital gains, because it’s not enough to just put new money into fixed income to get that. So you’re going to realize capital gains.
And because you’re probably going to be making some of these moves in, say, sophomore and junior year of high school, you’re going to be creating reportable income that increases your expected family contribution on the FAFSA.
Not only that, but you’re the one who has to do all of that if you have it in a taxable account. Or you’re paying a financial advisor 1% to do it for you.
Alternatively, you just suck up the 50-60 basis point cost of the 529 plan, you leave it alone, and you avoid the annual tax bill and the ongoing transactions to rebalance your accounts, to keep it an appropriate risk-based allocation for where you are on your way to school.
The second point is what about using a retirement account instead of a 529?
Absolutely, you need to be saving for retirement. And college should be secondary to that.
However, a lot of people seem to have this belief that your Roth IRA is invisible.
And it’s true that it’s not reported as an asset on the FAFSA. But the important thing to remember with the FAFSA and with the profile is that there’s four buckets, and any money that you could spend for college is going to go into one of those four buckets.
And those are parent income, parent assets, student income, and student assets.
The most favored nation among those four buckets is parent assets.
Your 529 as a parent asset is assessed at 5.6%. So $100,000 in 529 is going to cost you $5600 in expected family contribution.
If you take money out of your Roth IRA, it becomes parent income, which is assessed at 47%.
So that same $100,000, granted you’re not going to take it all out in year one, but let’s say you were going to take out $25,000 a year, that’s going to increase your expected family contribution by about $12,000 every time you do it.
So it’s far less beneficial to do it that way.
Plus, there’s a fixed number of dollars that you can put into retirement savings every year. You can do $19,500 into your 401(k), another $6500 if you’re over 50, and you can do $6000 into an IRA.
So if you use up all of your Roth money to pay for college, what’s left for your retirement?
There’s also a small number of years that you have to get from college to retirement compared with a 30-year-old who’s starting to save for retirement and for college has a much longer time horizon to accumulate those assets and is probably in a lower tax bracket.
So that was all a really lengthy way of saying I think you should have a 529.
Andrew Chen 1:03:29
That’s really helpful context. And it makes sense.
Definitely, you have finite tax-advantaged retirement dollars, so you have to think about how you allocate them.
One last thought I wanted to get your opinion on is, suppose the size of your retirement account wasn’t a huge concern. You have a really, really large combined 401(k), IRA, Roth IRA, all that stuff combined.
Let’s say you have $3 million. It’s more than enough for you to retire.
Would there be a viable strategy where you don’t have a 529 so you don’t take that 5.6% EFC asset hit?
You just go ahead and take out student loans. In the sophomore year, you start withdrawing money from the retirement account, so it’s not considered reportable income in the future.
And then when your kid graduates, just take out a final distribution to pay off the loans that you took out in freshman and early sophomore year.
Or am I overthinking that?
Ann Garcia 1:04:44
You certainly could do that. If you had those millions and millions of dollars, there’s really no reason not to. But I think that hypothetical person is extremely hypothetical.
I would also say people get really fixated on “How do I bring my EFC down?” and “How do I shield my assets from the EFC calculation?”
Far more important in driving what you’re going to pay for college are two things. Number one, your choice of school. And number two, your income.
Your income is really the vastly bigger factor in calculating the EFC. But you could have a very low EFC and choose a school that has very ungenerous financial aid policies, in which case, you’ve really shot yourself in the foot because you don’t have money and that really isn’t one of your choices.
If you want to give your child the widest range of college choices, then having a 529 is really the way to go. Having a budget for what’s reasonable for your family to pay for college is the way to go. There are tons of great ways to get educated that don’t cost $70,000 a year.
Right around Thanksgiving, they announce the Rhodes Scholar winners every year. And every year, about half of them are graduates of public schools that admit 50% of applicants, and that cost what public schools cost.
So your choice of school is not going to determine who you become. It’s not going to make or limit your opportunities. That is on you.
Andrew Chen 1:06:37
Ann Garcia 1:06:38
And who you are as an adult is about who you are. It’s not about where you went to college.
I was fortunate to go to a great school. And I live in a neighborhood of people just like me, many of whom went to schools that are not elite schools. And here we all are.
My business partner went to a school that’s far less highly regarded than mine. And obviously, it didn’t get me any further than it got him.
Great people are great people because they’re great people, not because of where they went to school.
And that may be easy for me to say where I have a kid who’s going to a great school, who got into one of those, but she would do great things no matter where she went to school.
She’s fortunate to have this opportunity. But part of the reason she has this opportunity is that we saved so that she would have that choice.
And we understood what college was going to cost us and we made a budget and we said, “If you get a scholarship that’s this big, you can go there.”
And she did, so that’s where we are.
Andrew Chen 1:07:53
All right. Well, this has been incredibly insightful. Thank you, Ann, so much for taking the time to share your wisdom and recommendations and advice with us.
Where can people find out more about you and your work and services?
Ann Garcia 1:08:07
I write a blog about paying for college called the College Financial Lady, and that is thecollegefinanciallady.com.
And then my financial planning investment management firm is called Independent Progressive Advisors, and we’re based in Portland, Oregon.
But look to my website first for college planning advice, the College Financial Lady.
Andrew Chen 1:08:27
All right. Well, we’ll make sure to link to all those in the show notes, and look forward to sharing these insights and tips with our audience.
Thank you so much again for taking the time to share your advice with us today.
Ann Garcia 1:08:39
Oh, it’s my pleasure. Thank you.
Andrew Chen 1:08:41
Take care. Bye.
Ann Garcia 1:08:42