College savings plans still underutilized

College savings plans still underutilized

January 28th, 2018 by Chris Hopkins in Business Around the Region

Christopher Hopkins

Christopher Hopkins

Photo by Contributed Photo /Times Free Press.

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Saving for college remains one of the greatest challenges for young American families as tuition rates continue to rise faster than inflation. A 529 college savings plan remains a powerful but underused tool for setting aside the necessary resources. And despite some significant changes wrought by the recent tax cut legislation, these plans continue to provide attractive benefits and deserve a closer look.

States have long recognized the need to assist their citizens in saving for college. Early iterations of discounted "prepaid" tuition allowed residents to reserve a slot in their own state's colleges and universities. Then in 1996, Congress approved section 529 of the Internal Revenue Code creating a new variant of the prepaid tuition plan that could be applied to any approved institution of higher learning, including technical schools, regardless of state residency.

In response to the legislation, most states rushed to set up their own individual savings platforms, known as 529 plans. An account can be opened in the name of any individual to save and invest for college. The person opening the account and controlling investments and disbursements is known as the "participant", while the prospective student is the "beneficiary." Total allowed contributions vary by state and range from $235,000 to $500,000.

The most appealing aspect of the 529 program is the tax treatment of investment gains. As long as the funds are used for approved educational expenses, the earnings in the account accrue tax-free. In addition, about 35 states offer limited state tax deductions for contributions to their own state 529 plans. Approved expenses include tuition and fees, room and board, textbooks and required computers.

Another attractive aspect of 529 plans is their flexibility. The plan participant may name a different beneficiary at any time who is a member of the same family. This can be very helpful if the original student secures scholarships or even decides not to attend college. And even in the worst-case scenario, the original capital contributions can be reclaimed in whole, the investment earnings are taxed, and a 10 percent penalty on the earnings may be imposed (the penalty is waived in the event of the student's death, scholarship receipt or military service).

The recently enacted tax cut legislation contains provisions affecting 529 plans, but did not reduce their long-term effectiveness in saving for college. The doubling of the estate tax exemption to $11 million per person eroded some of the tax benefit for potential contributors like parents or grandparents subject to the $15,000 annual gifting limitation.

Another notable change resulting from the tax bill is the inclusion of K-12 educational expenses in the definition of approved expenditures, including the cost of private elementary through high school instruction. Clearly this provision weakens the incentive for long-term investment in higher education, but allows some residents of high-tax states to benefit from a tax subsidy to help finance private school tuition.

While the 529 is an excellent tool, each state has its own plan and some are superior to others. In particular, note carefully the fees and expenses, which vary wildly and can eat up a significant portion of returns. Tennessee, for example, administers an excellent plan with a variety of investment selections and a relatively low 0.35 percent annual expense ratio. Keeping the costs down is perhaps the most important aspect after making the commitment to get started.

According to the US Government, only three percent of households had established a 529 plan as of the latest census data. Given the imperative of education for a competitive workforce, every family should take a closer look at this important tool.

Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.