Preparing for the costs of college is an important part of a comprehensive financial plan for most families with children. There are many ways parents can begin investing and saving for their children’s college fund in order to limit their need for student loans. However, there are many ownership, tax, distribution, and investment issues that need to be considered for many of them. One of which is the 529 Plan, named after the IRS code Section 529. Follow this expert advice to get one of many 529 Plans in place, and what to expect with it over time.
Time and compound interest can be your best friend or your worst enemy. The day your child is born is the optimal time to begin putting away money to pay for your child's college. The shorter your time-line, the more risk you take with the mutual funds in your plan. Start early with a 529 Plan to make it worth your time and money.
It is best to invest the money to pay for your child's college systematically. This will build a good habit, and has a higher probability of success than putting too much in all at once. Systematic dollar-cost averaging (DCA) is as important in funding your 529 as it is in funding your other investment portfolios.
Take the time to do your homework. Some states have prepaid 529s that allow you to lock in tuition rates at your state’s universities. These plans can be problematic, however, should college tuition rates continue to run well ahead of inflation and exceed returns in the stock market. We always recommend checking out your own state’s plan, especially if you can also get a state income tax deduction. Just like with most things you attempt in life: the more you prepare—the better the outcome.
Be careful: the 529 is not designed to be a liquid emergency fund. If you remove money for any reason but for higher education, it is treated like a premature distribution from an IRA. There is also a 10% penalty and a tax bill on any money you withdraw prior to age 59 ½ if you use it for other purposes than education. You will also lose your tax-free distributions if you use it for other purposes.
Once you have done your homework, you should definitely get a second opinion from an expert who is trained in college savings accounts. They should be able to help you confirm or correct your homework, answer any questions or concerns you might have, and help you get a 529 plan set up for you that will be perfect for your future college student(s).
It is vital that you consult with a knowledgeable CPA before using your 529 Plan’s money. You can actually lose substantial tax credits by paying too much from your 529 in one year.
Generally, you shouldn't make distributions to the school directly, or you run the risk that your 529 money will be treated like an outside scholarship. This could cause a reduction in financial aid for which your child may be eligible.
It is always best for the parent to own the 529. Ownership by a grandparent or another relative, for example, will cause distributions to be considered untaxed income to your student.
Putting too much money into your 529 could end up being a big mistake. Remember that the 529 is very illiquid. If an emergency should arise and you don’t have enough liquid cash, withdrawing funds from the 529 would be very costly.
Most advisors recommend you take a risk on your money if the student is many years away from college. As the day gradually approaches, you should gradually cut back on the risk.
If you plan to put several thousand dollars into any 529 plan, be sure to have a meeting, first, with a CPA or certified financial advisor who understands them well, and can also discuss other options that can provide similar tax benefits without the risk.
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