Rather than make a deal with the devil, it is smart to save for college in advance. Even so, it is possible to make mistakes that affect the amount of college savings, the earnings, or the financial aid or tax impact of the college savings plan.
Failing to Save for College
What are you thinking? Don’t assume that the financial aid fairy is going to magically cover your college costs. If you don’t save for college, you will have to borrow for college, which will increase your costs.
Sometimes, families argue that they shouldn’t save for college because they will be penalized for saving. Yes, there is a penalty for assets in the financial aid formula, including college savings plans, but it is a small penalty.
If a 529 college savings plan is owned by a dependent student or the student’s parent, it is reported as a parent asset on the Free Application for Federal Student Aid (FAFSA). This reduces eligibility for need-based financial aid by at most 5.64% of the asset value. For example, each $10,000 in such a 529 plan reduces aid eligibility by at most $564. That still leaves you with $9,436 to pay for college costs.
Families who save for college have more money to pay for college costs than families who don’t save for college. Every dollar you save will reduce student loan debt at graduation. It will also increase choice, giving you the flexibility to enroll at a more expensive college than you otherwise could afford.
If you start saving from birth, about a third of the college savings goal will come from earnings. If you wait to start saving, you’ll have a shorter savings window and less time for the earnings to compound. So, it is best to start saving for college sooner, since your greatest asset is time.
But, even if you start late, every dollar you save is a dollar less you’ll have to borrow.
Choosing the Wrong Type of Savings Account
Use a 529 college savings plan to save for college. 529 plans provide financial aid and tax advantages that are not available on other types of savings accounts.
Saving in an UGMA or UTMA bank or brokerage account will lead to a higher tax liability. It will also reduce eligibility for need-based financial aid by 20% or 25% of the asset value.
Using a Roth IRA to save for college will reduce aid eligibility by as much as half of the distribution amount, even for a tax-free return of contributions.
Prepaid tuition plans supposedly may offer peace of mind, but 529 college savings plans often provide more money for college and more flexibility.
Saving in an ABLE account can cause the remaining account balance to be seized by the state when the beneficiary dies.
Choosing the Wrong 529 Plan
It is best to shop around, comparing performance, fees and tax advantages for each 529 plan. More than two-thirds of the states offer a state income tax deduction or tax credit on contributions to the state’s 529 plan. Some states have much lower fees than other states. Direct-sold 529 plans tend to have lower fees than advisor-sold 529 plans. Investors should always consider their own state’s plan, but also the 529 plans of other states that offer lower fees. You can invest in any state’s 529 plan.
Wrong 529 Plan Account Owner
Saving in a 529 plan account that is owned by the student’s grandparent, aunt or uncle can hurt the student’s eligibility for need-based financial aid. If the 529 plan account is owned by anybody other than the student (a custodial account) or the student’s custodial parent, it can reduce aid eligibility by as much as half the distribution amount. This includes 529 plans that are owned by the non-custodial parent, if the student’s parents get divorced.
It is better to contribute to a 529 plan that is owned by the student or the student’s parents. Such 529 plans are reported as parent assets on the FAFSA, yielding more favorable financial aid treatment.
Failing to Save Every Month
Set up an automatic monthly transfer from your checking account or payroll check to your 529 plan. This will make it easier to save, since you will quickly get used to not having the money in your bank account.
Not Reviewing Your Investment Strategy Regularly
You should review your asset allocation at least once a year.
Generally, it is best to shift the mix of investments from a high-risk, high-return portfolio when the child is young to a less risky asset allocation as the college years approach. Most 529 plans offer age-based asset allocations that do this automatically.
Saving Too Much or Too Little Money
529 plans provide many options for leftover money, such as changing the beneficiary to a sibling, parent or grandchild, using the money for graduate school and taking a non-qualified distribution. However, it is best to avoid overfunding a 529 plan. Fortunately, this is a rare problem.
It is much more common for families to save too little money. Set a college savings goal, and use a college savings calculator to figure out how much to save each month. Aim to save at least the cost of a college education the year the child was born, which is about a third of future college costs.
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Taking a Distribution for K-12 Expenses
Taking a distribution for elementary and secondary school costs reduces the amount of time available for the earnings to compound.
Taking a Non-Qualified Distribution
The earnings portion of a non-qualified distribution is subject to ordinary income taxes at the beneficiary’s rate, plus a 10% tax penalty. In addition, non-qualified distributions may be subject to recapture of any state income tax benefits previously received.
So, think twice before taking a distribution to pay for transportation costs, insurance, medical bills, childcare, gym, eating out, entertainment and miscellaneous/personal expenses, none of which are considered qualified.
Not Considering the AOTC
The American Opportunity Tax Credit (AOTC) provides $2,500 in partially refundable federal income tax credits based on $4,000 in tuition and textbook expenses.
The AOTC is worth more per dollar of tuition and textbook expenses than a tax-free distribution from a 529 plan. So, you should carve out $4,000 in tuition and textbook expenses to be paid with cash or loans to qualify for the maximum AOTC before using your 529 plan to cover the remaining costs.