Saving for College: 529 Plans

Summary: If you want to save for college, there’s probably no better choice for Coloradans than the College Invest 529 plan.

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We live in an interesting time. There’s no question that, right now, having a college degree is really helpful both in getting and staying employed and in earning more while employed. But that doesn’t mean that college is the right choice for everyone, and some folks are beginning to wonder if the traditional college degree will retain it’s place of prominence for much longer.

Of course the purpose of an education is more than just preparation for employment, but certainly that’s a big part of why many folks choose to go to college, so this poses a dilemma. We don’t know if college will continue to be the “path” to career success, yet it is so expensive that most folks with children will need to save up some money ahead of time to help pay for it. My crystal ball is way too cloudy to definitively answer this but, should you choose to at least hedge your bets and try to save up some money in advance, I can give you some good advice on how best to do that.

The short answer is, especially in Colorado: a 529 plan. Like 401k and Section 125 plans, it’s named after a section in the tax code. It allows you to invest money for your child(ren) and the investment grows tax free, and then any qualified withdrawals (used for higher education expenses) are also tax free. It’s similar to a Roth IRA in the sense that you put after-tax dollars into it and then earnings and withdrawals are tax free, except the purpose for the money is different and the timeline is shorter.

While you can choose any 529 plan, in many states (including Colorado) it makes sense to choose your state’s plan because they offer additional incentives. In Colorado’s case, your contributions are tax deductible which, in effect, means you earn an automatic 4.63% return on your money when you deposit it. (You don’t actually get that money until you file taxes for that year, at that point it reduces the taxes you owe Colorado so that you either pay less or get a larger refund.)

They are way too many nuances to 529 plans to cover in one blog post (this site has lots of information), but here are the basics of what Coloradans needs to know:

  1. College Invest is the Colorado state plan
  2. Choose the Direct Portfolio
  3. Decide what your total goal is by the time your child(ren) graduate from high school and contribute accordingly
  4. Get started now

There’s much more to it, of course, including choosing how to invest the money, but those are the basics. We started ours for our daughter as soon as she had a social security number, because that’s required to open a 529 plan. (Because she was adopted at 9 months, and then had to go through the citizenship process, this was a little later for us than for many of you.) But you can even begin to save before they are born, either by putting away money that you will eventually transfer into a 529 plan after they are born, or by opening up a 529 plan and then changing the beneficiary once your child is born.

Once the account is opened, you can invest lump sums whenever you want, or set up automatic investments from a checking or savings account that occur every month. We did both, plus for a while we had a rewards credit card where the rewards went directly into the 529 account. You then choose your investment options, choosing between an age-based option (similar to target-date funds) that automatically shift to more conservative investments as your child approaches age 18, or by choosing a particular portfolio. The portfolios changed a bit in 2004, but since that change we’ve been in the “Growth Portfolio“, which is 75% stock/25% bond.

That might be too aggressive for some folks (especially as our daughter is about to begin her senior year in high school which means we’re close to the withdrawing phase), but because of our overall financial security, and because of the bond-like nature of our PERA pension, it was a good fit for us. For reference, here are the actual returns our account has earned (your account will always be somewhat different than the generic portfolio return because of the timing of your contributions).

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Note that the 10-year return currently includes 2008, which is pretty remarkable that it’s still so high. Going back to October of 2004 (when the portfolio changes occurred), our total annualized return has been 6.7%. At this point we are debating whether to shift the portfolio to a bit more conservative choice but, because the conservative portion of these portfolios are in bonds and that segment of the market has its own issues right now, we’re not sure. Given we still have 5 years left (senior year plus at least four years of college), equities are still likely to outperform bonds over that period.

Either way, this account has been incredibly successful for us (more on that below). Which brings up a big concern that some folks have – what if you don’t need the money? The reasons to not need the money can vary from your child ends up not going to college, to your child earns scholarships, to you actually saving and earning more than you need. Thankfully, there are options for dealing with each one of these.

    1. Your child doesn’t go to college: First, there are a variety of post-secondary options other than college that sill qualify. If none of those apply, you can always change the beneficiary to another child or even to yourself or eventually a grandchild, or you can withdraw the money for non-qualified expenses. If you do the latter you pay federal and state taxes plus a 10% penalty on any of the earnings that you withdraw (not on the contribution portion). For any of the contribution portion you withdraw that you took a Colorado tax deduction at the time of contribution, you would have to make Colorado “whole” on those taxes. While this may sound bad, it’s really not. In the end it’s “extra” money that you wouldn’t have had otherwise (because it would have gone to the college).
       
    2. Your child earns scholarships: For whatever dollar amount in scholarships they get, you can withdraw that amount of money for other purposes. Similar to #1 above, you would have to pay federal and state taxes on any of that that was from the earnings portion (not contributions, as you already paid tax on those), but you would not have to pay the 10% penalty. You can of course still pay for expenses not covered by the scholarship, and you can leave the money in for future use (or for a future beneficiary).
       
    3. You end up with more money than you need: Your options are the same as #1 above.

For us, we may actually end up being in the position of having more than we need. Because we did a good job of contributing (especially a fair amount in the early years so it could compound), and because the returns have also been pretty good (recently the earnings portion of our portfolio exceeded how much we’ve contributed), it’s likely Abby’s total expenses will be less than what we currently have in the 529 plan (barring a severe market downturn in the next couple of years, or she decides to go to med school). (Make no mistake, this is a good position to be in.)

We can’t really tell yet, because we don’t know for sure which college Abby is going to, how much it will cost, what if any scholarships she might receive, how many years it might take her to finish, or whether she chooses to pursue anything beyond a bachelor’s degree. Plus there are other factors, including the American Opportunity Tax Credit, which means that at a minimum we’re going to want to spend $2000 a year from outside of the 529 plan (and perhaps as much as $4000) in order to claim that credit. But at this point my best prediction is that when she finishes her college work, we’ll have to decide whether to withdraw what’s left or leave it for possible future use by us or Abby’s possible children. Again, a good problem to have, and definitely not a potential reason to shy away from using a 529 plan.

If you live in Colorado and want to save some money for your child(ren)’s higher education, you should definitely be looking at a 529 plan as part of your larger financial plan. If you choose to work with me, this would certainly be part of our discussions. And keep in mind that while it’s better to start right after they are born to maximize the compound investment earnings potential, it’s never too late. Even if your child is in college now it makes sense to funnel your payments through the 529 plan. Even though they might not be in there long enough to really benefit from the tax-free investment growth, you will still get the 4.63% Colorado state tax rebate. When most folks are paying $20,000 and up (sometimes way up) a year, 4.63% isn’t nothing ($926 if it was $20,000).

Section 125 Plans

Summary: If you aren’t taking full advantage of Section 125 plans, you’re giving money away.

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Most school districts (and most employers in general) give you access to Section 125 plans which, much like the better known 401k plan, is named after a section of the federal tax code. Despite these being around for a while, many folks don’t completely understand them or take full advantage of them. While the specifics of what your employer offers may vary a little, most are pretty similar. I’ll use Littleton Public Schools as my example, but most likely your employer will be very, very similar.

The reason Section 125 plans are so useful for you is that they allow you to pay for various things pre-tax. How beneficial that is for you depends on what tax bracket you’re in, the more money you make, the more beneficial it is. Most educators are typically in the 25% or 28% federal tax bracket, and everyone in Colorado pays 4.63% in state income tax , so that means you’re typically saving between 29.63% and 32.63% in income taxes for every dollar you can put into a Section 125 plan. But, as an educator paying into Colorado PERA, you save an additional 8% because your Section 125 contributions also come out pre-PERA deduction, which brings your total savings to 37.63% to 40.63% (FYI – this also saves your school district money, as they don’t have to pay contributions on that amount either.)

So, what are these Section 125 plans? There are typically five components:

  1. Paying insurance premiums pre-tax (Premium Only Plan, or POP)
  2. Health Savings Accounts (HSA, goes with High-Deductible Plans)
  3. Health Flexible Spending Account (FSA). If you don’t have an HSA, can be used to pay for out-of-pocket medical expenses.
  4. Limited Purpose Flexible Spending Account (Limited Purpose FSA). Can be used in addition to an HSA to pay for out-of-pocket dental or vision expenses only.
  5. Dependent Care Flexible Spending Account (Dependent Care FSA). Can be used to pay for child care expenses.

Let’s look at each one briefly. (Note: this is not an in-depth look, just an overview, we can delve into much more detail in person.)

Premium Only Plan: Unless you are within 3 to 5 years of PERA retirement*, this one is a must. It takes whatever you pay in health, dental and vision insurance premiums and exempts those amounts from both income taxes and your PERA contribution. It’s basically free money – take it.

Health Savings Accounts: There’s a lot to say about High Deductible Plans and HSA’s but, to keep this brief, if you have a high-deductible plan an HSA is perhaps the best tax-advantaged option out there. It’s often referred to as a “triple-advantaged” plan, because contributions, earnings and withdrawals (for eligible expenses) are all tax free (as a bonus, your employer often contributes to this as well – more free money). Essentially, you never pay taxes on this money. Many folks just use it to pay their healthcare expenses on a yearly basis but, if you can afford to pay those expenses with other money, letting it accumulate and grow over time (invested in low-cost index funds) can be an incredible wealth builder. (2017 Contribution Limits: $3400 individual/$6750 family, additional $1000 if over 55, balance rolls over year to year.)

Health Flexible Spending Account: This existed before HSA’s and, for those folks who don’t have a high-deductible, this is still a great option. The money you put in and then use for eligible expenses is never taxed but, unlike the HSA, this is “use it or lose it” so you don’t want to put more in here than you can spend in a year. (2017 Contribution Limits: $2600)

Limited Purpose Flexible Spending Account: When paired with an HSA, this money can be used for dental or vision expenses. It’s a great way to put additional money aside tax free but, unlike the HSA, it is also use it or lose it (some employers allow you to carry over up to $500 from one year to the next). (2017 Contribution Limits: $2600)

Dependent Care Flexible Spending Account: If you have young children in day care, this is a great option to pay at least some of those expenses pre-tax. Again, it’s use it or lose it, so plan the amount wisely. Many years ago I had a conversation with someone who said they didn’t bother with this because they just deducted it when they filed their income taxes. This is not optimal, as if you do that you lose the 8% PERA savings and, depending on your itemized deductions, you may not get to claim the entire $5000. (2017 Contribution Limits: $5000).

So, let’s put some example numbers with this. How much savings you realize varies tremendously, not only based on your tax bracket, but based on the size of your family and what expenses you have, but I’ll try to pick a “typical” educator family (even though there is no such thing). For this example, I’m going to have the educator be married with two children, one of whom is in day care. The educator will cover themselves and their children (but not their spouse) for health and dental, and be employee-only for vision. They will choose the Kaiser High-Deductible Plan and the Low Cigna Dental Plan. They will max out the Dependent Care Flexible Spending Account with $5000, contribute $100 a month to their HSA (plus the district contribution), and pay for all insurance premiums pre-tax. (Their spouse would probably realize additional savings by utilizing some of these at their employer for their coverage.)

  1. Kaiser HDHP Employee Premium: $391.29/month
  2. Cigna Low Option Dental Employee Premium: $34.76/month
  3. VSP Employee Only Employee Premium: $11.29/month
  4. Dependent Care Flexible Spending Account: $416.66/month
  5. HSA Contribution: $100 month (district adds $85/month)
  6. No Limited Purpose contributions

That totals $954 a month, or $11,448 a year (not including the $1020 the district contributes toward the HSA). Assuming the family is the 25% federal tax bracket, that equates to a savings of $4308 in a year in taxes and PERA contributions. Keep in mind that you also have $2220 in your HSA to either spend or preferably rollover from year to year, for a total “savings” of $6528. Again, it could be a lot less than that if you’re doing employee only coverage (although still worth it), or a whole lot more if you’re doing family coverage, using Cigna for health care, and/or contributing more to your HSA and the Limited Purpose FSA.

As with everything financial, the specifics of your situation matters, so if you choose to work with me, we’ll work through all the permutations. In a future post, I’ll talk more about retirement accounts (401k/403b/457 plans) and how, when you combine them with Section 125 plans, you can dramatically lower your taxes.

*Very Important: If you are within 3 to 5 years of PERA retirement, you want to opt-out of all Section 125 deductions because it will lower your retirement benefit (lowers your HAS). I think there is probably at least a 40% chance that this rule will change in the 2018 Colorado Legislative session, in which case you would no longer opt-out when near retirement, but you also would “lose” the 8% PERA savings each year prior to that. Still very much worth doing because of the federal and state income tax savings.

Photo credit: reynermedia via Foter.com / CC BY