Money Mommy

Stuff your mom should have taught you, but didn't…

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Month: May 2016

Flow Chart for a 529

The 529 is a valid option for saving for college. You place money for future college expenses in a special account called a 529.

These accounts were named after Section 529 of the IRS code that originally created them back in 1996 in response to the need to save for ever rising college costs.  The concept is simple.  You set money aside in a special savings account administered by a state or educational institution.  There are no federal tax savings when money is first placed in the account, although many states will allow a deduction off the state income tax.  However, there will be no tax on any future capital gains, interest or dividends if funds are later withdrawn for qualified educational expenses.  Depending on your tax bracket, you could save a full one third of this future growth that would otherwise be forfeited to federal taxes.

Let me repeat, the 529 is a valid option for saving for college for some individuals.

Let’s do a simple flow chart and see if they are for you.

First, are you contributing enough to your 401K at a work to receive the maximum amount that your employer will match?  If your employer matches the first 5%, then you should have 5% allocated to your 401K.  If he matches the next 3% at only half as much, then you should still allocate an additional 3% for a  full 8% to your 401K.  You have just doubled the first 5% of your savings.  The next 3% received a fifty percent boost.  No other investment offers such immediate guaranteed returns.

If you are maximizing your 401K, read on.  If not, then the 529 is not for you.

Second, are you fully contributing to your IRA?  Currently (2016) you can contribute $5,500 to an IRA – either Traditional IRA, Roth IRA or a combination of both. (i.e., $3,000 to a Traditional IRA and $2,500 to a Roth IRA for a combined total of $5,500.)  Individuals over 50 can contribute an additional $1,000 as a catch-up contribution.  IRA’s can be funded for both the husband and wife provided at least one spouse has taxable earned income of at least the current year’s IRA contributions.  IRA’s can be opened at any bank or brokerage house.  You should check with your tax advisor before opening your IRA and then you should fund your IRA every year.

So, if both you and your spouse are fully funding your IRA, read on.  If not, then the 529 is not for you.

Do you expect to apply for and receive financial aid in the form of federal grants and loans?  When my husband and I filled out our first FAFSA form for our eldest son, we were amazed how much we were expected to contribute to his education. We were further dismayed to learn that the 529 we had diligently saved counted directly against us when it came to determining how much federal financial aid he would receive.

If you do not expect to receive any financial aid, the 529 my be for you.  If you expect/hope to receive federal aid, then the 529 is not for you.

Will you be eligible for education credits such as the American Opportunity Credit, Hope Credit or Lifetime Learning Credit? One of my favorite moments when completing taxes is asking parents for their students 1098T college tuition statements.  If their income is under $80,000 ($160,000 if filing joint), they are eligible for the American Opportunity Credit (AOC).  The AOC can reduce the tax bite by a full $2,500 for each of four years, a total savings of $10,000 over your child’s college career, based on qualifying education expenses of at least $4,000 each year. The Lifetime Learning Credit can reduce their taxes by a further $2,000 as long are attending school.   The government, however, does not allow double dipping.  If you pay college expenses with 529 accounts, you can not use those same college expenses to qualify for the AOC or other education tax credits.

If you will qualify for education credits based on your expected income, do not invest in a 529.  If you are lucky enough to be highly compensated and will thus not qualify, then read on.

Do you have superfluous funds that you are willing to allocate solely to education?  When you start a 529, that money is earmarked for education.  If you use it for anything else, you will pay penalties and taxes on the growth.  Of course, if your child does not attend college, you can share the 529 with another family member, or even use it yourself to further your own education.  I, for one, would prefer not to limit my investment dollars.

As I stated earlier, the 529 can be a fine way to save for college.  But without a crystal ball, I am reluctant to place limited resources in such a limiting account.  The ROTH IRA will overcome virtually all the concerns about saving for college, and will leave you maximum control over your investment dollars in the future.

 

 

 

 

529’s? Forget it!

I have to just come out and say it….Do Not Open a 529 college fund for your kid!

A quick “google” of 529’s will give you a plethora of sites singing the praises of the 529 college fund. The concept is really simple.  Start saving early.  Your money will grow tax free.  When you take it out to pay higher education expenses, none of the money will be taxed.  Your child will walk debt-free  across the stage at commencement.

Unfortunately, life is just not that simple. And unless you have a crystal ball, the 529 is not necessarily a good thing.

Suppose your child is incredibly talented and leaps right from high school to a music or acting career.  Or perhaps they are athletic and head right into the big league.  No college for them.  You cannot touch the money you had saved in a 529 without incurring penalties and taxes.   Imagine how disheartening it would be if your child decided to live in your basement and play video games.  You would be even more discouraged about that 529.

Our friend’s son went right from high school into the marines. They certainly were proud of him.  They had also dutifully saved for his college education in a 529 account.  They can’t touch that money without triggering penalties and taxes unless they use it for education.  Their only child is making a career of the military and does not expect to need it for his education.  The only option is to give the 529 money to a distant relative or bite the bullet and pay the taxes and penalty.  Neither choice is very appealing.

But suppose you have a student who is following the traditional path of high school to college to career.  Aren’t you glad you started that 529 for them now!  Not so fast. Nearly all students will fill out the Fafsa, and your child’s financial aid will be negatively impacted by your prudent college savings.

The Fafsa is the Free application for federal student aid form.  By submitting the Fafsa form you will be told your “expected family contribution” or EFC to pay for college.  This will determine the federal grants and loans that your student is eligible for.  The Fafsa form is incredibly detailed, requesting information from  the parents’ and the child’s tax forms, their savings, investments, wages, property, partnerships, 529 savings etc. Parents are currently expected to contribute 5.64% of their assets towards the EFC; students contribute 20%.  The bite is harder on earning; Fafsa uses 22 – 47% of the parents’ earnings and 50% of the student’s income to calculate the EFC. Put another way, nearly  everything you have saved and everything you earn can be used to reduce your student’s federal grants and loans.  (There are a few exceptions such as retirement accounts and the family home.  You’ll find out how to use these to your advantage in this blog entry. – MoneyMommy)

Okay, despite everything I said, you still want to save in a 529 account. You’ve heard this is the best option, and I haven’t managed to convince you otherwise. While I commend your due diligence, let’s see what happens to your taxes now that your child is in college.  There are awesome education credits that can reduce your taxes by $2,500 for up to four years. That is a savings of $10,000! After four years, the Lifetime Learning Credit can generated up to $2,000 more for continued higher education each year.  Wonderful!  Except for one small problem.  You used a 529 account to pay his college expenses.  The government does not allow double dipping when completing your taxes.  You will not receive these education credits for any expenses that were paid for with 529 funds.  Your diligence just cost you $10,000 in higher taxes.

So, unless you are quite well off and are maxing out all of your retirement accounts, have lots of spare change, don’t expect to receive any financial aid, and won’t qualify for any education credits, do not start a 529 account!