Tuesday, October 26, 2010

Saving for your kid's college education via 529 plans

The rising cost of college tuition is staggering. In 2010, the average cost of tuition plus expenses at a private university was $40K! And last year alone, tuition at private universities increased an average of ~4.5%. If you start doing the math on how much little Junior's college expenses will be in about 15 years, its enough to make your head spin!

If you're planning to send your child(ren) to college and don't want Junior(s) to be riddled with debt upon graduation, you better start saving up now. And if you haven't already, you should look into opening a 529 plan for each of your children.  As it's pretty foolish not to take advantage of a 401K plan to save for retirement, I'd argue that its just as foolish to not take advantage of 529 plans for your kids.  For those of you who don't know what a 529 plan is, I hope this post saves you a bit of time and money, and encourages you to open up an account.

What is a 529 plan?
A 529 Plan is designed to help you set aside money for your child's future college expenses.  529 plans generally come in two flavors:
    • Pre-paid tuition plans: lock in tuition prices at eligible public and private colleges and universities; they're generally designed to be used for schools in the state offering the plan (although they may be transferrable to other states).  Assuming that tuition continues to increase at the breakneck pace that it has over the past few years, its not a bad option if you know where your child is likely to go to school (which is pretty unlikely).  Also, this is by far the more conservative approach.   
    • College savings plans: allow you to set up an account for a student and choose among several investment options such as mutual funds or money markets.  You defer taxes on the earnings (which means you have more dollars working for you every year) and when the child is ready to enroll in college, the distributions are tax free!  Note, there are pretty heavy penalties for withdrawing funds from these accounts for any purpose besides education.  Consider the college savings plan the more flexible and aggressive approach since you can choose the types of funds in which to invest and your upside is not capped.  Given the time horizon that you have before Junior goes to college, I believe the savings plan makes the most sense; you're likely to get more for your money.
Since I decided to invest in a 529 savings plan for each of my kids, the rest of the post will
focus on how to choose among the various savings plans out there.

Which 529 plan should I choose?
After doing a ton of research, I chose to go with the Virginia Education Savings Trust (VEST).  Keep in mind, I live in CA; but the CA 529 plan does not offer any incentives to CA residents so I decided to shop around.  Check your state's plan before choosing to look elsewhere since some offer healthy tax incentives for residents who invest in in-state plans.  I chose the Virginia 529 plans for a few reasons:
    • Among the best in performance 
    • Some of the lowest fees among 529 plans
    • Broad spectrum of investment options: you have the ability to pick and choose between a wide variety of funds based on investment philosophy (aggressive versus conservative) or even investment strategies tailored to your child's age (starts aggressive and becomes more conservative over time)
Here are a few common questions about 529 savings plans.

Do I have to be a resident of the state that offers the 529 plan?  
No, you do not have to be a resident of the state that offers the 529 savings plan that you choose.  For example, I live in CA but use the VA 529 savings plan.

If I choose a 529 savings plan from a particular state, must I use the funds for in-state schools?  No, you can use your 529 plan for any college or university in the US, regardless of what state offers the plan.  I use the VA 529 plan but can use the funds for any college/university.

What happens if my child never enrolls in college?
If you're not confident that your child will go to college, you should definitely think twice before opening up a plan. The federal government applies a 10% penalty on earnings from the account are not used for educational purposes.  In addition, those earnings are also taxed as income which can be painful.  

How much should I put into the savings plan?  I don't have much money to spare...
The sooner you start investing in a 529 plan, the better.  Since your earnings are tax deferred, you essentially have more money working for you over time.  So if you have $100 to invest today, it's worth much more than the $100 you would invest a year from now.  If you're thinking about opening up a 529 plan, I'd start now and set up a very modest recurring payment every month.  You can always adjust the investment over time.

Hopefully this helps you get started and saves you a ton of time.

There is a ton of information available online about 529 plans.  Here are a few links to learn more.

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