Using 529 Plans to Save for College

August 14, 2017 | Paul R. Ruedi CFP®
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Higher education costs have risen substantially over the last few decades, leaving many people worried about how they will fund these costs for children or grandchildren in the future.  In its most recent survey of college pricing (2016-2017), the College Board found the average cost of a year of tuition and fees alone was $9,650 for an in-state student at public universities while out of state students paid an average of $24,930.   Those students lucky enough to attend private universities paid even more with an average cost of $33,480 for their tuition and fees.  When you add in another $10,000 - $11,000 per year in housing and meals and another $3,000 - $5,000 in supplies and transportation, the total cost of a year in college can easily reach $25,000 - $50,000.  With the cost of 4 years in school totaling $100,000 - $200,000, how does a family even approach saving to fund such large amounts by the time a child is old enough to go to college?  Fortunately, they have been provided with a useful tool for doing so, the 529 savings plan.

What is a 529 savings plan?

A 529 plan is a special type of savings account that allows investments grow tax deferred and ultimately tax-free if the proceeds are used for qualified education expenses.  These plans are provided by the states and nearly every state has at least one, Illinois, for example, has three.  The state the plan is sponsored by does not necessarily have to be the state where the beneficiary attends school. 

The plans are funded with after-tax dollars and contributions are not deductible on federal tax returns, though they may be on some state tax returns.  Like a 401k or IRA, in a 529 savings plan, you invest your contributions in a portfolio of mutual funds or similar investments offered by the plan provider.  The options are generally diversified mixes of mutual funds with various stock/bond allocations.  The account balance goes up and down based on the performance of the investments in the account.

The big sticking point is that in order to avoid taxes on the gains in the account, the proceeds must be used for what are deemed qualified education expenses.  Qualified education expenses include tuition and fees, books, computer technology and equipment (including internet access), special needs equipment, and some room and board expenses.  If the proceeds are not used for qualified education expenses, earnings on those proceeds will be subject to tax at your ordinary income tax rate plus a 10% penalty.  There are some exceptions to the penalty rule though, for example if the beneficiary dies, becomes disabled, or receives a scholarship, in which case the earnings will avoid the 10% penalty but will be subject to tax at your ordinary income tax rate.

529 plans provide some extra help when it comes to funding higher education, but the majority of the progress towards this goal will be based on advanced planning and diligent saving.  Let’s walk through an example to show how a family could use one to save enough to fund $25,000 per year in education expenses to pay for college for a newborn child 18 years from now.  How would they even begin to plan for something like that?

What will the cost of education be in the future?

First of all, they would need to consider how much the cost of education will rise.  It would be nice to assume that the cost of education will rise at the rate of inflation, roughly 3%, but in reality, it has been rising roughly twice as fast, around a rate of 6%.  Whether it will continue to rise this much in the future, we can’t be certain.  But for planning purposes, it is something people must consider, and plan for accordingly.  6% price increases over 18 years mean that what costs $25,000 in yearly education expenses today will cost over $71,000 by the time the child enters college.  Not only that, this amount will continue to go up while the child is in college.

Remember that $71,000 is in future dollars, which in today’s dollars would be around $42,000.  That brings our $25,000 yearly cost for 4 years of education, to around $312,000 ($175,000 in today’s dollars) total by the time we actually go to pay for the child’s education. 

How much do we save?

So clearly the dollar amount that will need to be accumulated is huge – but how much would they need to start saving on a yearly basis to accumulate this amount?  Let’s assume the funds in the account will be invested in 100% stocks for the first 13 years, then will become more conservative for the last 5 years with a 50% stock 50% bond mix (this is by no means a recommendation that this is what people should do, just what we would consider a typical example).  When we run the numbers through our financial planning software, we find that they would need to start saving around $7,000* per year to be confident they will have enough saved to pay for college.  No small amount, and this example is kind of a best case scenario as it assumes the 529 plan was opened soon after the child was born and had the maximum amount of time to compound.  Start saving any later and the amount that needs to be saved on a yearly basis increases exponentially.

Impact of the 529 plan

So just how big is the impact of using a 529 plan vs not using one?  For comparison let’s assume the family in the example above chose to fund the same education goal with a traditional taxable brokerage account, with gains taxed at a 20% long term capital gains rate.  Over the course of saving and paying for those same education expenses, they would incur around $50,000 in unnecessary taxes!.   In this scenario, they would need an account balance around $350,000 instead just $300,000 in the 529 plan!  That means they would have to up their savings from $7000 to $8000** a year!

Do we fund the entire amount? 

The numbers above may look scary to some, unachievable to others.  It may make sense for a lot of people to plan to save enough to cover a portion of the total amount needed and cover the rest by taking out loans.  This allows them to save less during younger, lower income years in exchange for repaying education loans later in life when they have advanced in their career and are making more money.  To show how this may make sense for some people, let’s consider the same example of funding $25,000 per year in today’s dollars by taking out loans for roughly half that amount at 8% interest, paying it back over the next 15 years.  In this case, the person only has to save half as much, around $3,500 per year, in the years leading up to college   The cost is that they have to pay back the loans which will require them to pay around $17,000 per year in the future (which is around $10,000 per year in today’s dollars).  This trade off may make sense for people whose incomes will rise over time, and therefore will find it easier to pay back $17,000 per year in over 20 years in the future than to save an extra $3,500 per year over the next 18 years.

Final thoughts

Saving enough to pay for higher education is something that will require thoughtful planning for any household that is considering sending their children to college.  Useful tools like the 529 plan provide some assistance, but the vast majority of funding this large of a financial goal comes down to whether or not people carefully plan for education expenses and commit themselves to saving the necessary amount.  For some people it may be impossible to save the amount necessary to fully fund higher education expenses, but they shouldn’t let that discourage them from committing themselves to saving as much as possible to take advantage of the tax treatment of 529 plans.  The most important thing is to know your options and to plan accordingly.  If you don’t know what your options are or are just completely overwhelmed by the thought of funding higher education costs, you may want to talk to a financial advisor.

 

 

Disclosures:

*7,000 is the amount of saving required in a 529 plan to provide an 81% probability of funding the education goal when all funds are invested in a 100% stock portfolio (expected return: 11.44%; standard deviation: 20.78%) for the first 13 years, and 50% stock 50% bond portfolio (expected return: 8.16%; standard deviation:10.56%) for the last 5 years.

**8,000 is the amount of saving required in a taxable brokerage account to provide an 83% probability of funding the education goal in the example when all funds are invested in 100% stock portfolio (expected return: 11.44%; standard deviation: 20.78%) for the first 13 years, and 50% stock 50% bond portfolio (expected return: 8.16%; standard deviation: 10.56%) for the last 5 years.

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