It would help if you think of 529 plans and Coverdell ESA plans as a bridge to help supplement the cost of college for your children. It will be nice if you can have 529 plan savings that can pay for the entire cost of the college. However, as the New York Time journalist Ron Lieber laid out in this excellent book, that the price that you pay for your child to go to college could range from $100,000 to $300,000 over 4 years. Therefore, it can be hard for parents to save so much money for college and as he suggests in this book, it will be a good idea to save approximately one-third of that money using these college saving plans.
It helps to have a real world example. So, for this example, I am assuming that we have a family that is saving and investing $100 per month in a 529 plan and/or a Coverdell ESA from the time their child was born until the child turns 18 years old. Assuming a conservative 10% return, that money will grow to $60,191 when the child turns 18.
Let’s pause here and think about this. You invested $21,600 over this period (18 installments of $1,200) and that investment grew to more than $60,000. That’s great and shows the effect of compounding returns. So, our post-tax contributions (money invested) are $21,600 and gains are $38,591 (60,191-21,600).
If this money was invested in a regular brokerage account, you could take this money out for anything you want and you would pay capital gains taxes on the gain portion. So depending on the tax bracket you are in, you would typically pay 15 to 20% of $38,591 in taxes. The advantage of investing through a 529 account and/or Coverdell ESA account is that if we spend this money on qualifying education expenses (tuitions and related fees, room and board, books and supplies, computers and related equipment), you never have to pay any taxes on the gains part.
College Scholarships and 529 Plans
I have talked to many parents who hesitate to invest in a college savings plan because they are not sure what will happen to these investments if their child gets any scholarships or some people worry whether their child will be able to get any scholarship if they have saved money in their 529 plans. I want to address those concerns in this article.
There are two types of scholarships that colleges award to incoming applicants. Need-based scholarships and merit-based scholarships. 529 and Coverdell plans don’t impact merit-based scholarships at all. These plans have a small effect (about 5-6%) on the need-based scholarships when filling out the FAFSA application. Custodian accounts (like UTMA/UTGA) have a higher effect (about 20%) on need-based scholarships.
If the 529 account is owned by someone else (like a grandparent) that account has no impact on the need-based scholarships until you start withdrawing the money. Once you do start withdrawing the money, they are reported as untaxed income to the student and that can impact next year’s financial aid.
Do Scholarships Affect 529 Plans?
This is an important concern. What if your child earns a scholarship and you no longer need all the money that you have saved? IRS Publication 970 allows a special exemption for scholarships. If your child earns a scholarship, you are able to withdraw the amount of the scholarship without paying the penalty. You will need to pay taxes on the earnings portion of the withdrawal, but there is no penalty.
When I am reading statements like these, I have a hard time visualizing the numbers. So, I want to share some examples. We will use the numbers that I referenced above. Ending Balance in the 529 Account is $60,191, you invested $21,600 and the capital gains are $38,591. Therefore, your principal makes up approximately 36% of the total balance (21,600/60,191) and the remaining 64% is the gain component.
Whenever you withdraw any money out of your 529 plan, there will be no tax or penalty for 36% of your total withdrawals because that is the amount of your contributions. Even if you spend that amount on non-qualified educational expenses (Read: anything), there will be no tax or penalty on that portion of your withdrawals since those are your post-tax contributions and you have already paid taxes on those. However, if you did withdraw this money and used it for non-qualifying educational expenses, you will pay taxes and a 10% penalty on the gains. How much taxes you pay on these withdrawals depends on the tax bracket you are in because this withdrawal will be added to your income. Therefore, in this case, let’s say you are in a 30% tax bracket, you will pay $11,577 ($38,591 X 30%) in taxes and $3,859 ($38,591 X 10%) in penalty.
Let’s walk through some scenarios.
Scenario 1: Let’s say that your child gets a scholarship to attend the college for $120,000. First, that’s wonderful. Second, you have $60,191 saved in your 529 plan and you can use that money for paying other college costs as I mentioned above. If there are no other qualifying education expenses left over, you can use it for another child, yourself or spouse. If that is not the case, and you don’t want to use this money for any education expenses, you can withdraw all of it without penalty. You will pay taxes on the $38,591 part of it using your regular income tax rate but there is no 10% penalty. So you will pay $11,577 in taxes assuming you are in the 30% tax bracket.
Scenario 2: Let’s say that your child did not get any scholarship and the qualified college costs for the four years are $90,000. Congratulations, this is what you saved for. You can use the entire $60,191 in your 529 plan and you will not pay any taxes or penalties.
Scenario 3: Let’s say that your child got a scholarship for $30,000 and you will have $35,000 in other qualifying expenses over the next four years. In this case, you can withdraw $35,000 out of your 529 plan tax-free and penalty-free. You can withdraw the remaining balance in your 529 plan, which is $25,191 (60,191-35,000) by paying taxes only on the earnings part. Remember that 36% of your balance is made up of your contributions. So, you will not pay any taxes on that part. You will only pay taxes on the remaining 64% of $25,191, and there will be no penalty on this withdrawal.
You can work these scenarios to your situation and change the numbers accordingly.
To summarize, the two benefits of investing through 529 plans are that some states allow a tax deduction for investing through 529 plans and you will pay no taxes if the money is used for qualified education expenses. However, in some situations it may make sense to save that money in a regular taxable brokerage account. Not only you will pay only 15-20% capital gains tax on those gains but you will also have thousands of investing choices whereas you have restricted choices when you are investing in a 529 plan. Every family is different and this answer will be different for you but in most cases, it will be a good idea for you to figure out a range of amounts that you think that you will need for your child to attend college. Let’s say that you come up with a range of $50,000 to $125,000 in four years. In this case, it will make sense to have at least $50,000 in the 529 plans and rest in other brokerage accounts. That way, even if your child does get any scholarships or grants, you can still use $50,000 on other qualified expenses.
I hope this was helpful. It certainly helped me think through these thoughts and examine my options. For what it’s worth, I am taking the same approach for my kids. I am targeting to reach the low number in my range through our 529 plans and investing the rest using a regular brokerage account and using one of these six mutual funds to do that. If you have any questions, just post them here or email me, I will be happy to help.
Bonus Tip: You can always pay for the qualifying college expenses using your credit card and earn some travel miles and get reimbursement from the plan administrator later to pay for that credit card. That way, you can use those travel points to a well-earned vacation while your child is attending college.