Saving and paying for higher education is a very real and relevant concern for many people. Finding a suitable strategy is sometimes challenging, especially since the cost of college is not only tuition; it’s also room and board, transportation, books and supplies, among other expenses.
You have many options when saving for your child or grandchild’s education. Among the top contenders in college-savings strategies is a state-sponsored 529 college-savings plan. A 529 plan is an account that allows you to invest specifically for future education expenses. The accounts are administered at the state level, and are managed by financial services company.
Before opening a 529 plan or any college-savings account, it’s important to evaluate the pros and cons of each plan and then decide which best aligns with your family goals. Here are a few of the advantages and disadvantages of the 529 plan. We’ll also take a look at an alternative to a 529 plan that provides greater flexibility in how you can use your money, can potentially be withdrawn on a 100 percent tax-free basis, and doesn’t count towards your Expected Family Contribution (EFC). You’ll see why this is important later in this article.
PRO: Plans offer tax breaks
The most significant benefit of 529 plans is the fact that funds are tax-advantaged. The earnings that accumulate are tax-deferred, withdrawals are exempt from federal income tax and are also generally exempt from state tax for “qualified higher education expenses” (books, supplies, tuition, fees, room and board). Note: This does not include a new car or a shopping spree for the beneficiary.
Account holders will not only get a tax break in many states on the contribution or a portion of contributions, but you also won’t pay capital gains on the appreciation of your 529 account when the money is withdrawn. A family of four who earns a hypothetical $50,000 per year and contributes a total of $2,400 per year would get a tax dollar benefit of anywhere from $38 in Rhode Island to $480 in Indiana.2
CON: Account can lose value
Like an investment, a 529 account can gain or lose value over time. To help protect your investment, many plans offer an age-based option that automatically moves your money into more conservative allocations as your beneficiary gets closer to attending college. This option may help your account preserve its principal and earnings. However, it still isn’t guaranteed that your account won’t decline in value.
PRO: Account holder has control of funds
When you open a 529 plan for a child, you, the account holder, remain in charge. This means you control the funds in the account and the beneficiary cannot withdraw money, change investment options or do anything else without your consent. Once the beneficiary and account holder are identified at the time the account is created, friends and family members can also contribute to the plan going forward.
CON: High fees
State-sponsored 529 plans often come with higher fees than other savings and investment vehicles and because 529s typically house relatively conservative investments, high fees can sometimes decrease an account’s growth significantly. About half of all 529 plans charge a yearly maintenance fee – which averaged about $20 – for administrative costs. Broker fees are also a source of these additional costs, and they are at least 1% of the total asset, which can add up over the long term.
PRO: Attend school near home or abroad
A positive of the 529 plan is the funds may be used at any eligible higher-education institution in the U.S. as well as some colleges overseas, including Germany, New Zealand, and Philippines. Plenty of foreign institutions of higher education, including more than 100 Canadian schools, are eligible under the rules permitting tax-free withdrawals from a 529 plan. If the intention is not to enroll in a foreign institution but to participate in a study abroad program, you can use 529 plan funds to pay for it if the study at the foreign institution is eligible for credit at the student’s U.S. home institution.
CON: May reduce financial aid
Many parents use 529s as one part of a larger plan to cover college expenses – a plan that may also involve financial aid. In that case, maintaining a student’s financial aid eligibility is important when considering who should be listed as the owner of the 529. As the custodial parent of a dependent student, your non-retirement investment assets are assessed at a maximum 5.64% rate in determining your child’s Expected Family Contribution (EFC). Any 529 accounts under your ownership are counted as parent assets for this purpose.
For example, let’s assume you have 529 accounts worth $100,000 on the day you file the FAFSA federal aid application. You must report the $100,000 along with your other countable assets, which will likely increase the EFC by $5,640. Higher EFC means less financial need.
529 plans can also affect the application for financial aid for a private college or university. Under the “institutional methodology” created by the College Board and used by some schools to calculate eligibility for private institutional aid programs, 529 savings are included in the parents’ net assets, which are assessed at 3 percent to 5 percent, depending on the school. You should always meet with a financial aid officer and determine how they calculate the award.
PRO: Money can be used to pay for tuition at K-12 schools
A recent tax rewrite gave a boost to tax-free college savings plans. The federal tax code allows you to use money in 529 plans, up to $10,000 a year, to pay for K-12 private school tuition.
CON: Not all states automatically follow the federal definition for their 529 laws
More than 30 states and the District of Columbia offer a benefit at the time money is put into the account: a state income tax deduction or credit for contributions to 529 accounts. Yet some states have language that specifically defines the accounts as being college savings — and that phrasing could prove troublesome unless state laws are amended. If you live in certain states and you withdraw funds before that happens, you may risk having to repay a state tax deduction you’ve already received — or facing state tax on the investment gains in your account.
It is important to discuss with your financial professional about the plan you’re invested in and ask about the potential consequences of a withdrawal, since it depends on where you live, and which plan you selected.
PRO: Flexibility of beneficiaries
If the beneficiary does not use all the funds or decides not to attend college, the account holder can change the beneficiary to another family member. You can change your beneficiary at any time or transfer a portion of your investment to a different beneficiary. To maintain the tax benefits, the new beneficiary must be an eligible member of the previous beneficiary’s family, such as a sibling, an aunt, stepchild, first cousin or a spouse.
CON: Penalties if the money isn’t used for education
What if your child decides not to attend college? Or doesn’t use all the money saved in the plan? One of the downsides of a 529 plan is there are stiff penalties if you don’t use the money for qualified higher education purposes. When a withdrawal is taken but it is not used for designated expenses, then the earnings may be subject to income tax plus a 10% penalty tax.
THERE IS AN ALTERNATIVE TO 529 PLANS!
You have many options when saving for your child or grandchild’s education and staying on track with your own financial goals. You may not think of life insurance as a way to accomplish this, but an indexed universal life (IUL) insurance policy can be a very useful college saving strategy. The policy cash value accumulates on a tax-deferred basis and, if managed properly via withdrawals and/or loans, it can be withdrawn on a 100% tax-free basis. This money can help assist with college expenses, as well as unrelated costs, with no penalties or restrictions on the uses for that cash value.
Plus, the policy value can grow tax-deferred and is protected from downside market risk. So when the market is up, your policy value will grow, but when the market is down, your money is protected and you will never lose any of your hard-earned savings. You can benefit from interest credits up to cap, without the risk you could face with investments in the stock market.
Another great benefit is if your children decide not to go to college, that money can be accessed for other uses. You can continue to let the value grow tax-deferred and later withdraw money for a down payment on a house, fund a new business, or provide for retirement.
Example: Meet Robert and Melissa
Robert and Melissa are 35 years old and have a 3 year old son, Noah. They would like to start saving for Noah’s education, as well as have money for their retirement and additional life insurance coverage. They discuss their goals with their insurance professional and can set aside $500 per month ($6,000 per year) to achieve these goals.
Robert decides to purchase an IUL insurance policy with planned premiums of $500 per month. The policy value can grow income tax – deferred and interest is credited to the policy based on the percentage change of an index. After 15 years and $90,000 in paid premium, Robert’s initial death benefit of $203,608 has grown to $331,006 at age 50. Robert could receive supplemental income of $162,160 when he needs it for Noah’s college funding, and at age 58, still have a $160,569 death benefit for his family. Once he reaches age 58 through the end of his life, he will have over $700,000 in net death benefit.
Robert and his family will not only receive an income tax-free death benefit, but also access to the policy value for college funding or other needs. They can accomplish their many goals all with one policy and have the flexibility to make modifications if their needs change in the future.
Take the time to plan now for college funding, protecting your family and retirement.
Complete this form to learn how an Indexed Universal Life policy can fit your needs:
1 What’s the Price Tag for a College Education? Accessed March 29, 2017
2 Benefits of college 529 plan vary by state. Savingforcollege.com. May 21, 2007
© Copyright Insurance Insight Group. All rights reserved. All examples are hypothetical only and not intended to be a predictor of actual results.
This material has been prepared for informational and educational purposes only. It is not intended to provide, and should not be relied upon for, accounting, legal, tax or investment advice. Please consult with a professional specializing in these areas regarding the applicability of this information to your situation.
Indexed universal life is not a stock market investment and does not directly participate in any stock or equity investments. Market Indices do not include dividends paid on the underlying stocks, and therefore do not reflect the total return of the underlying stocks; a market-indexed insurance product is not comparable to a direct investment in the equity markets. Clients who purchase IUL are not directly investing in a stock market index.
Indexed universal life policies are designed for long-term accumulation and not for short-term liquidity. However, if your needs change, the policy allows you to withdraw all or part of the cash value subject to certain limitations. Withdrawals may be subject to surrender penalties imposed by the company. Amounts withdrawn may also be subject to tax liability or tax penalties. Partial surrenders and loans affect policy values and death benefits.