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Should I Open a 529 Plan For My Child or Grandchild?

 

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You may have heard talk recently about 529 plans and how they may no longer be a good place to put your college savings.

In the State of the Union address on January 20, Obama proposed eliminating some of the tax benefits associated with 529 plans. But he has since backtracked, and 529 plans are as alive and well as they have ever been.

It may still make a lot of sense for you to use a 529 plan, but first you need to understand how 529 plans work and how they can make it easier for you to save for your child’s college education.

How do 529 plans work?

529 plans are special investment accounts that make it easier to save for college by giving you some pretty big tax breaks. In fact, 529 plans work a lot like Roth IRAs, just for college instead of retirement.

Just like a Roth IRA, there’s no Federal tax deduction on the money you contribute (we’ll talk about state taxes in just a second). But the money grows tax-free while it’s inside the account, and if it’s withdrawn for qualified higher education expenses (read: college and beyond), it also comes out tax-free. Just like a Roth IRA!

But 529 plans have one more big potential tax benefit that Roth IRAs don’t have. Some states allow you to deduct your contributions for state income tax purposes if those contributions are to your home state’s plan. That deduction can make it even easier to save.

The benefits of 529 plans

The big benefit of using a 529 plan is the tax breaks. Other than a Coverdell ESA, which is also a great option, there’s no other account where you can get this kind of tax benefit for your college savings.

But there are some other benefits as well.

When you open a 529 plan, you’ll have to name a beneficiary, which is simply the child for whom you’re saving. But if that child doesn’t end up needing all of the money you’ve saved for college, you have the option of changing the beneficiary to another child, or even to yourself, your spouse, or eventually to a grandchild. That gives you some flexibility to use the money where it’s needed instead of having it go to waste.

There are also very few contribution limits with 529 plans. There are no income restrictions, so anyone can contribute and still get the same benefits. And you’re generally allowed to contribute up to $14,000 per child per year, with married couples allowed to contribute $28,000 per child per year. There are even special cases where you could contribute up to 5x that amount in a given year. A benefit the Obamas actually took advantage of in 2007 when the couple contributed $240,000 to a 529 plan for their daughter’s educations.

Finally, it’s worth noting that 529 plans are run by states, with each state having one or more plans. But you’re under no obligation to use your state’s plan. So if your state’s 529 plan comes with high fees and/or poor investment choices, you can simply choose another plan. The only time you would be obligated to go with your state’s plan is if you’re looking to get that state income tax deduction. Otherwise, you’re free to go with the best option.

The downsides of 529 plans

While there are some great reasons to use a 529 plan for your college savings, there are some downsides to be aware of too.

The biggest downside is the penalty you would face if you wanted to use the money inside your 529 plan for something other than education expenses. Withdrawing it for any other purpose would not only cause that money to be taxed, but to be hit with a 10% penalty.

There are some exceptions to that 10% penalty. If your child receives a scholarship, you can withdraw up to the amount of the scholarship without penalty. And there are exceptions for death or disability as well, but beyond that, your flexibility is limited.

And unlike a Coverdell ESA, money within a 529 plan can’t be used for K-12 expenses (without facing that withdrawal penalty). Only higher education expenses qualify for tax-free withdrawals.

Finally, your investment options within a 529 plan are limited, though that’s not always a bad thing. It’s kind of like a 401(k), but it’s the state choosing your investment options instead of your employer. And just like with 401(k)’s, some states make good choices and others make bad ones. The good news is that you’re not locked into any one state’s plan, so you can certainly shop around.

How do 529 plans affect financial aid?

Some parents are afraid to use a 529 plan because they’ve heard that it will hurt their eligibility for financial aid. And I’m here to tell you NOT to worry about that.

Here’s the deal: 5.64% of the money you have inside a 529 plan will be counted as part of your financial aid eligibility. Which means that 94.36% of it WON’T count. At all. And the truth is that any money you have outside of your house or retirement accounts will be counted in exactly the same way.

In other words, it’s much better to save ahead and have the money available than to not save and avoid that small ding towards financial aid. Especially when you consider that most financial aid comes in the form of loans anyways, which we all know isn’t exactly free money.

There is one catch to worry about with 529 plans and financial aid though, and it involves grandparents.

Grandparents can open a 529 for their grandchildren, but if they actually withdraw money to pay for that child’s college expenses that withdrawal will count as the child’s income for financial aid purposes. And since the child’s income is the factor that counts the most against financial aid eligibility, this can be a big issue.

There are a couple of ways for a grandparent to contribute to a 529 plan and avoid this issue:

  • Grandparents can contribute directly to a parent-owned 529 plan, instead of opening their own. The big downside with this tactic is that the money is then controlled by the parents, not the grandparents, which may or may not cause a family conflict.
  • Grandparents could simply wait until the child’s last year of school before they help with expenses. Without another financial aid application on the horizon, the consequences won’t make a difference.

Bottom line: 529 plans are still a great tool

If you’re ready to save money specifically for college, a 529 plan is still a great option.

The tax advantages make it easier to save without busting your budget, especially if your state gives you an income tax deduction.

And with the flexibility to choose any state’s plan, contribute almost as much as you want, and change beneficiaries at any time, you can make it work for you no matter what your situation.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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Pay Down My Debt

5 Steps to Prepare for a Child While in Debt

Young couple calculating their domestic bills

By Matt Becker, MomAndDadMoney.com

Money was the thing I worried about most before our first son was born, and my work as a financial planner with other parents tells me that I’m not alone. There are a lot of new financial responsibilities that come with starting a family and it can be hard to figure out what needs to be done, how much it will cost, and how to prioritize it all.

If you have debt, all of those questions can be even scarier. Debt can feel suffocating, and many of the parents I work with want to get rid of it as fast as possible.

But while getting to debt-free is a fantastic and admirable goal, I usually encourage new parents to pump the brakes a little bit.

Before you go into full-on debt attack mode, there are a few steps you can take that will not only make it easier to pay off your debt, but will give your family more financial security in the meantime.

Step 1: Find some big wins

Freeing up room in your budget is almost always the first step towards reaching any of your financial goals. Whether you want to pay off debt or save for the future, you’re going to need some free cash in order to make it happen.

The quickest way to do this is to focus on what I like to call “big wins”. A big win is simply a one-time effort that reduces or eliminates a regular bill, saving you money month-after-month without requiring any ongoing effort.

Here are some examples of big wins:

  •  Negotiating your cable bill. Or maybe even cutting it completely.
  •  Finding a lower-cost cell phone plan (check out companies like Republic Wireless and Ting).
  •  Finding a bank that doesn’t charge you ridiculous fees, and maybe even pays a little  interest, such as Internet-only banks.
  •  If you really want to go big, you could downsize your home or trade in your car for a less  expensive model. Those are the kinds of decisions that could save you hundreds of  thousands of dollars over your lifetime.

With just a few one-time efforts, you could find yourself with a couple hundred dollars extra per month. Then it’s time to put that money to work.

Step 2: Build a cushion

No matter what kind of debt you have and what the interest rates are, it can be a good idea to put at least a small amount of money into a savings account before going into full-on debt attack mode.

The reasoning is pretty simple: having a baby is going to change your life in a lot of ways, and the reality is that it will take you some time to adjust. In the meantime, there are going to be expenses you didn’t plan for and having a little bit of savings will allow you to handle them with cash instead of putting them on a credit card.

That simple habit of handling the unexpected with cash instead of debt is possibly the biggest key to not only getting out of debt, but staying out of debt. And it’s a big mindset change, so the sooner you can start, the better.

The easiest way to build your savings cushion is to take some of the money you’ve saved with your big wins and set up an automatic transfer that sends it from your checking account to a savings account on the same day every month. With that consistent progress, it won’t be long before you have $500 to 1,000 dollars saved up, which should be enough to handle most unexpected expenses that come your way.

Step 3: Protect yourself

One of the best things you can do for your growing family is ensure that they will have the financial resources they need no matter what happens to you. Generally this means getting two things in place: insurance and wills.

I have to admit, I love insurance. No, it’s not the most exciting topic in the world. But when it’s done right it’s the best way I know to protect my family financially from some of life’s worst-case scenarios.

Here are the big types of insurance to consider as you start your family: Health

  •  Life
  •  Disability
  •  Liability

Writing wills is one of the most morbid topics in all of personal finance, but for new parents it’s also one of the most important. More than anything else, a will allows you to name guardians for your children, ensuring that they will be in good hands no matter what.

Step 4: Test drive 

This is a tip I give to all expectant parents, whether they have debt or not, mostly because it can help make sure that having a baby doesn’t send you into even more debt.

A few months before the baby gets here, estimate how much the baby will cost you on a monthly basis (babycenter has a good tool for this) and start putting that amount into a savings account. This will do two big things for you:

It will let you practice living on your baby budget before you actually have to do it.

It will help you build up that savings cushion we talked about in Step 2.

The combination of practice and savings cushion will make the whole adjustment easier, less stressful, and less likely to lead to more debt.

Step 5: Attack that debt!

Finally! After all of that we’re finally ready to start attacking that debt!

With those other pieces in place, you can send extra money towards your debt without the prospect of one financial mishap messing up your progress. You have a little cushion, you have the worst-case scenarios handled, and you have some practice living on a tighter budget. Now you can crush that debt with confidence!

There are two schools of thought when it comes to which debts to pay off first.

One is called the “debt snowball” and encourages you to pay your debts in order of balance, with the lower balance debts being paid first. Proponents of this method say that the motivation of quickly paying off individual debts makes it more likely that you will keep going.

The other is called the “debt avalanche” and encourages you to pay your debts in order of interest rate, with the highest interest rates being paid first. This is the approach that will save you the most money, as long as you stick with it.

No matter which approach you take, make it automatic just like you did with your savings cushion. Putting those extra payments on auto-pay will make sure that you’re attacking that debt consistently month-after-month and getting to debt-free as fast as possible.

Did you have debt when you were starting your family? What did you do to make it easier?

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Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

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