Welcome to a series of posts sponsored by ScholarShare, California’s 529 college savings plan.
Back to school season may have you, like me, thinking about saving for college and maybe even stressing out over it.
A number of parents have understandable fears about the ramifications of owning a college savings account. There is uncertainty about how or when to withdraw, the impact it may have on financial aid or worry about what happens if child doesn’t use it.
I think it’s worth tackling these fears head-on, because fear is a huge reason why people don’t take 5 minutes to open and fund a 529 college savings account like ScholarShare (with as little as $25).
Note: I’ve done my own pretty extensive research as a ScholarShare ambassador and owner of an account for my daughter. I was a financial adviser, but am not a practicing one anymore so this isn’t intended as financial advice. Do your own research as rules and laws vary by state and are always subject to change.
ScholarShare is California’s 529 college savings plan. Money invested in a 529 college savings plan grows tax-deferred and withdrawals for qualified higher education expenses at eligible higher education institutions are free from federal and California state income tax.
If money is withdrawn for non-qualified expenses, the growth in the account is subject to state and federal tax in addition to an additional 10% federal tax and a 2.5% California state tax. The additional taxes are often referred to as penalties. This is similar to non-qualified withdrawals from an IRA or 401 (k) prior to age 59 1/2.
What Are the Eligible Higher Education Institutions?
Eligible higher education institutions include:
- Community college
- Trade/career/technical schools
- Any type of degree or certificate program
- Graduate degrees
A number of accredited foreign institutions qualify, too. Contact the institution of interest to verify or check the Federal School Code Search.
What Are Qualified Expenses?
The student must be enrolled at least half of the time or full time. Qualified expenses include:
- Mandatory fees
- Certain room and board costs (if a child is living with parents, this can be a qualified expense—ask your financial adviser how much you may be able to withdraw as room and board reimbursement)
- Mandatory equipment and supplies
What if My Child Receives a Scholarship?
Talk to a financial adviser for specifics but there is some leeway here. You may withdraw 529 principle funds up to the amount of the scholarship—provided the scholarship covers qualified expenses, which they usually do—without penalty or additional tax. If there are earnings withdrawn to cover the scholarship value, these will be subject to federal and state tax without any additional taxes applied.
Earnings withdrawn from the ScholarShare account in excess of the scholarship value that aren’t used for qualified expenses, however, will be subject to federal and state tax, an additional 10% federal tax and an additional 2.5% California state tax.
What if My Child Enrolls in a Military Academy?
Thanks to the the Military Family Tax Relief Act of 2003, attendance at a U.S. military academy will be treated as a scholarship (above) for purposes of non-qualified withdrawals from a 529 plan. The value of the education can be withdrawn without penalty though the earnings portion will be subject to tax, just like a scholarship. Talk to your financial adviser about how this will impact you.
Does Having a 529 College Savings Plan Impact Financial Aid Eligibility?
A number of parents shy away from 529 college savings plan because they fear it will impact their child’s ability to qualify for financial aid. Here is the deal… Any asset owned by a parent or the child enrolling in college will be considered on a financial aid application.
A 529 college savings plan is usually considered to be the asset of the owner. Owners can be parents, grandparents, aunts, uncles, friends or anyone relevant in your child’s life.
If the owner is the parent, 5.6% of the 529 college savings plan balance is considered as Expected Family Contribution (EFC), which is used to determine how much financial aid a student is eligible to receive. Most parental assets are considered at 5.6%.
EFC is calculated using a formula that is established by law, but I’ve read that the consideration of investments in a ScholarShare account varies by school. Things that go into consideration may include family size, income, government benefits (like social security) and number of kids who will attend college in the same year. Refer to the EFC guide for in depth details.
Custodial savings accounts such as UGMA or UTMA accounts (in my past life as a financial adviser, I could not see why anyone would open these but this is another can of worms) are counted as 20% toward EFC, negatively affecting a financial aid application much more than a 529 plan would.
A 529 college savings account owned by grandparents, aunts, uncles or anyone else that isn’t the student or the student’s parents doesn’t count toward Expected Family Contribution. But, be cautious about deliberately structuring a financial plan that involves other people. I’ll leave it at that.
I Can Afford to Send My Child to College. Why a 529 Plan?
In this case, the tax-free growth and tax-free qualified withdrawals are of the most benefit to a person in this scenario, who may also be in a higher tax bracket.
However, you will want to work closely with your financial adviser and perhaps be diligent about only saving only the amount necessary to cover your child’s college expenses in order to avoid the 10% penalty and taxes. Remember, if there are funds leftover when the beneficiary is finished withdrawing, you may gift the account to another family member or use it for your own higher education expenses.
In our case, our ScholarShare 529 college savings plan is a much more tax advantageous way to save than our regular brokerage account. But we have no plans to overfund it. In fact, based on my own personality, I’d rather underfund it slightly and not worry about a penalty.
Seeing that if my daughter chooses Harvard, my husband’s alma mater, we’re facing a tab of approximately $440,000 including room and board so I’m not to stressed yet about hitting a penalty. However, should she choose UC San Diego or another school with significantly less tuition expense than Harvard, that might leave a few hundred thousand extra in the account that we would need to make a non-qualified withdrawal to release since we only have one child.
Ultimately, if you’re in a position to fully fund a college savings account to cover the entire cost of college, talk to your financial adviser to help decide what you are most comfortable with.
What if My Child Chooses Not to Attend an Eligible Institution or Skips College Entirely?
You may change the beneficiary to another family member. Or, you can make a non-qualified withdrawal which is subject to state and federal taxes, an additional 10% federal tax and an additional 2.5% California state tax.
In the event that you need to make a non-qualified withdrawal due to death or disability of your child, you may with draw the money without penalty. The earnings in the account would be subject to state and federal taxes, just like they are in any other brokerage account.
As a ScholarShare ambassador, I have the ability to organize a webinar with a ScholarShare representative who will answer your questions about saving for college. Shoot me an email at katie @ lajollamom.com or leave a comment if this is of interest to you. I would like to try to organize one in the fall.
- 5 Things to Do at Harvard University with Kids
- How Much Will College Cost When Your Kids Need to Go
- Why Your Child Needs a 529 College Savings Plan Now
- Saving for College in California: Is ScholarShare Right for You?
Visit ScholarShare to open a college savings account for your kids!
*Disclaimer: Though I was a financial adviser in a former life, this isn’t intended to be financial advice so seek counsel from your licensed financial adviser before taking action. Though some of this information applies to 529 college savings plans across the country, I am only speaking based on personal experience with ScholarShare, a plan that we personally own. Your financial situation may be different than ours. Please see the ScholarShare disclosure booklet for more details.