Gil’s Musings

Should You Start College Fund for Unborn Child?

“It’s never too early to start saving for college.” You’ve probably heard that before, but as education costs rise, the word “never” is becoming increasingly important.

It’s not too early to start the day a child is born, or even before they’re born. In fact, it’s not too early to start before any grandchild has been born, or even before the parents are married.

Thanks to the unique properties of 529 college savings plans, future grandparents can start saving for their grandchildren’s college education while their children are still in college themselves.

Sound ridiculous? Maybe not. After all, the Wall Street Journal recently pointed out that setting up a 529 plan for an as-yet-unborn child or grandchild can not only help pay for the rising cost of college but can also help with estate planning.

An early 529 strategy can become an effective way of passing on assets to help your descendants without incurring estate taxes. While your principal is contributed from after-tax income, the earnings grow tax free, much like a Roth IRA. The only difference: 529s must be used for education

Anyone can set up a 529 plan, and you can designate the beneficiary then or transfer ownership of the plan at a later date. You just cannot open one for yourself, and any beneficiary you name must be a relative. The beneficiary pays no taxes on withdrawals, provided the money is used for qualified higher education expenses. (If the money is used for non-education expenses, it triggers a 10% penalty.)

Those tax advantages are a big part of the reason to begin saving sooner rather than later. As the Journal pointed out, the average cost of a four-year private college is now almost $165,000, and the cost is rising by almost 4% a year. That means that even an investment return of 8% would have a hard time overcoming the rising costs of education. We often recommend fully funding the account as though it were needed at today’s college prices.

If you set up a 529 plan before the next generation arrives, you can designate any future grandchild in any proportion you like. What’s more, you can keep control of the fund and control the distributions. You can also cut off errant kids and reshuffle the beneficiaries. If you wind up having no children or grandchildren, or they decide not to go to college, you can simply name another beneficiary.

Couples can give as much as $28,000 annually per recipient, and 529 plans are allowed to use five years of giving at one time. Donors face recapture if they don’t live past the five years, but growth never has to be recaptured. The calculations are also lumped by year, so year-end gifts roll off very quickly.

We have also seen grandparents recoil from 529’s because of unequal numbers of grandchildren. You can fix that with the kids giving to each other in order to square things up. The kids can also open 529’s for each other, with the plans of naming their own children later as beneficiaries.

One word of caution: 529 balances can alter a child’s chances of receiving financial aid. But if you have assets to be thinking about large gifts, then they likely wouldn’t qualify even without a 529.

As with any investment, the longer you wait to get started, the more earnings potential you’re losing. Starting early lets you take greater advantage of a long-term strategy, and because the 529 plan is designed for education, you’ll probably be less tempted to actively trade the investments. That enables you to recognize the greater opportunity of doing nothing – as I discussed in this earlier post. Based on our analysis, the less frequently an investor sells, the more likely he or she is to come out ahead.

Done right, 529s can be an effective in both preparing for the rising cost of college and reducing taxes on your estate.

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