Financial Literacy Month : 3 Questions You Should Ask Yourself Before Setting Up a 529 Plan

If you have a child or are expecting at some point, your thoughts turn to planning for their future. One of the biggest challenges, parents face when thinking about their child’s future is how to pay for the ever increasing cost of college. According to the National Center for Education Statistics undergraduate price of tuition, room and board at public universities rose 40 percent between 2001 & 2012.

One of the best things any parent can do to ease the cost of college is by saving through a college savings plan such as the 529.

Congress created 529 plans in 1996 as a way to help with paying for college. 529 accounts can be used at four-year colleges as well as some two-year schools. You can set one up directly from your state. Currently every state and the District of Columbia offers a 529 plan of some kind.  The biggest benefit of setting up a 529 plan for your child is that earnings aren’t subject to federal tax if you use the funds for qualified education expenses. Expenses include tuition, room & board, books, fees, even computers and internet access.  While there are plenty of ways to save for college, the 529 plan is the most advantages so here are some questions you might want to ask yourself before setting one up.

1. Should I set up a prepaid plan or a savings plan?
There are two basic types of 529 plans the prepaid and investment plan. The prepaid plan offers the option of buying tuition credits and using them in the future. Essentially you get to lock in the cost of college at today’s prices.

The second type of 529, the savings plan is the investment plan. When you set up this type of plan you contribute funds on behalf of a beneficiary and that money can be invested based on a portfolio you choose.

When deciding between the pre-paid and the saving plan a couple of things to keep in mind. Do you expect your child to go to an in-state institution? Do you want to lock in tuition rates? How do you feel about room & board and other costs not being covered by the college savings account?

If your family is very confident about where the child will attend school, then a pre-paid plan is right for you. If there’s uncertainty about where your child will attend, school consider the savings plan. The savings plan may be right for your family if you want a plan that covers all qualified higher education expenses. The plan also has a flexibility of both the investments and the number of credits your child will take in the future then consider the savings plan.

2. Should I be the custodian or should it be someone else?
One of the biggest advantages of a 529 plan is that anyone can set up the account, parents, grandparents, aunts, uncles. Anyone. Usually, a parent or grandparent is the account owner, and the child is the beneficiary. Bear in that mind the impact of the plan on a child’s financial aid eligibility. If your family is trying to decide whether a parent or a grandparent should be the account owner on a child’s 529 plan. If a parent or child is the owner of a 529 plan, the account does count as an asset for the child’s Free Application for Federal Student Aid (FAFSA). The amount of aid the child is eligible is reduced by 5.64% of the account value.

However, if the account owner is the grandparent, then it’s not listed on the student’s FAFSA until the student starts making withdrawals from the account. Aid is reduced by 50 percent when the student makes withdrawals because the distributions are counted as income. One way to avoid the 50 percent penalty is by setting up two 529 plans for the same beneficiary. One plan can list mom or dad as the custodian, and the other can list a grandparent. When it’s time to take distributions start with the parent owned plan first and empty that account before going through the grandparent owned plan. Some plans do allow you to switch custodians so make sure it’s possible before setting up the

3. Should I set up an in-state 529 or an out-of-state 529?
Another advantage of 529 plans is that you can set up the account regardless of the state you live or where your child will attend school. For example, a resident of New York can set up a Colorado 529 plan especially considering that Colorado has a matching program that gives eligible applicants up to $400 a year for five years. Although state residency doesn't matter when enrolling in a 529 plan, it is wise to look for a plan within your state. Your state may offer a tax deduction for your contributions. Other incentives may include matching your contributions like Colorado, a bonus for setting up automatic contributions or waiving fees.

It can be a little difficult and overwhelming when you decide to set up a 529 plan. You do have to do a little homework before setting up an account. A good place to start is by reviewing Morningstar’s annual 529 plan rankings. It will give you insight on not only on the performance of the plan but information on fees and the overall process as well.

Thank you to our guest contributor, Mina Ennin Black, Financial Planner and the founder of Life Event Financial Planning & InTheBlack financial workshops. She is a personal finance expert that has been featured in DailyWorth, Yahoo Finance, Business Insider, Ebony magazine, Investor’s Business Daily, Bankrate, NY Times, GoGirl Finance and other publications.