A 529 college savings plan is a program sponsored by your state, or another state, in which you save money for a beneficiary and pay for education expenses. The Maryland 529 college savings plans are the only 529 plans that offer an annual Maryland State income deduction, and any earnings and contributions can be used tax free for eligible education expenses.
You can withdraw funds tax-free for most college expense. And many college savings plans – including Maryland’s plans – offer additional state or federal tax benefits. Some states offer 529 “prepaid plans”, but I’m going to focus here on the so-called “tax advantage” plan. I find that these are more appropriate to most of my clients who have children.
Furthermore, college savings plans can be very flexible.
You can use the funds for college expenses. This includes many trade schools, and even elementary or secondary public, private or religious school. Up to $10,000 can even be used to pay down student loans.
When I work with financial planning clients who have children, I spend a considerable amount of time developing reasonable estimates for the future cost of college. I also work with clients on minimizing the financial impact of the college decisions. Changes in wealth and income can have complicated effects on the FAFSA and/ the CSS Profile. A Maryland 529 plan is frequently a valuable tool for doing this.
You can usually, though, get a pretty good idea of what your out-of-pocket college expenses will be. Simply consult a “net price” calculator for a mix of schools that you think your child might consider.
The net price, or average out-of-pocket cost after financial aid, tends to vary by income more than any other single factor.
For instance, at the University of Maryland – College Park households with incomes between $30,000 and $48,000 pay on average about $12,000/year. Households making over $110,000 pay on average $25,000/year.
When your child is first born you will have nothing more than a hunch about what schools to compare. And barely more than a hunch about what their household income will be in 18 years. I don’t think it’s worth obsessing over. Saving anything is better than saving nothing, and a state tax deduction every year will ease the pain of savings.
A good rule of thumb for determining the amount your annual contribution to estimate the current net price for your income level and contribute 1/5 of that amount each year.
Sticking with our University of Maryland – College Park example, the overall average net price for a year of school is about $18,000 (actually $17,723 according to Niche.com) our rule of thumb would suggest an annual contribution of about $3,600 which is $18,000 ÷ 5.
Because of the power of compounding, getting an early start with a college savings plan is smart. One fear of many parents is ending up with more money in the 529 plan than they need. We use several strategies for dealing with this. One that can make sense is to create two different 529 plans for each child and invest them differently.
Call the two plans 529 #1 and 529 #2.
You will invest 529 plan #1 solely in stocks (e.g. the Maryland 529 plan’s “Global Equity Market Index Portfolio”). Contribute to this plan ONLY while the balance in the plan is less than the current net price for one year of school. In other words, using the numbers above, you’d CONTRIBUTE to this plan when the balance is less than $18,000. You will adjust this to mach the net price of your benchmark in the year you are making the decision.
If the balance in 529 plan #1 is MORE than a single year’s cost, contribute to 529 plan #2 instead. Invest this plan, unlike plan #1, entirely or almost entirely in bonds. Examples would be the Maryland 529 plan’s “Portfolio for Education Today” or “U.S. Bond Index Portfolio”). And if the TOTAL of plan # 1 and plan #2 has grown to more than 4x the current net price, you can take a year off to avoid overfunding the plan.
Why avoid overfunding?
You can withdraw excess contributions from a college savings plan. If you do then you might owe taxes on capital gains plus a 10% penalty. That’s not catastrophic, but the “two plan strategy” helps manage this.
You’ll first take qualified education expenses from plan #1. You funded plan #1 earlier and invested in stocks (which historically have appreciated more than bonds). As a result, it probably has the most growth. Plan #2 was invested entirely in bonds so it likely have less growth. Any surplus funds you withdraw will likely have a smaller exposure the taxes and penalties.
If this sounds complicated, don’t worry. You can always us the age-based investment options in your 529 college savings plan to avoid sweating the details. Or you can set up a time to do quick phone call with me. We can chat and see if you might find it helpful to hire us for a comprehensive college funding analysis.
Keep in mind that the strategy laid out here does not constitute investment or tax advice. Nothing here shall be considered a solicitation to buy or an offer to sell a security, or any other product or service, to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the laws of such jurisdiction.