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Your Initial Investment: Starting Off Right

Early Investment can have a big impact with a 529 college savings plan

Tax-Free Compound Growth Potential

Like with many financial investments, 529 college savings plans are effective because of potential impact of compound interest. Your 529 plan contributions - as well as any additional funds earned through your account investment performance - will be invested in whatever investment portfolio you have selected for your plan.

The long-term impact of early investment is even more pronounced for 529 college savings plans. Not only will any account growth continue to be invested, but it is exempt from federal income taxes (as long as the funds are used for qualified educational expenses).

While 529 college savings plans are effective no matter how much time remains before your child or grandchild plans to attend college, the earlier you open an account, the longer your investment has the potential to grow. For many people who are saving for college, one of the most effective strategies is to set up recurring, automatic contributions (for example, adding $100 each month) to help build your account over time.

Early Contributions, Maximum Impact

For those who are able to do so, there are many benefits to front-loading your savings with a larger initial contribution to a new 529 plan.

Compounding means that there is potential to receive interest on your contributions and any earnings those contributions produce. That is to say, if your investment earns money, that money can also earn money, as long as it stays in your account.

For example, let’s assume that an investment account grows at the rate of 5% per year under two different scenarios.

These scenarios are hypothetical examples for illustrative purposes only and do not predict future values of any investment option in a 529 college savings account. Investment performance is not guaranteed and will vary with general market conditions.

Scenario A: A $1,000 contribution each year, for 10 years

In Year One, $1,000 is contributed to the account. With a 5% rate of return, that investment has grown to $1,050. In Year Two, another $1,000 is added to the account - bringing the total account value to $2,153 by the end of the second year, including 5% growth. This pattern continues through Year Ten.

At the end of Year 10, a total of $10,000 has been contributed to the account - and the total account value has grown to $13,207. That’s an increase of more than $3,200 over the actual amount contributed to the account.

Scenario B: An initial contribution of $10,000, with no subsequent contributions

In Year One, $10,000 is contributed to the account. With a 5% rate of return, that investment has grown to $10,500. In Year Two, no additional contribution is made - but the account continues to grow at 5% annually, bringing the total account value to $11,025. This pattern continues through Year Ten.

At the end of Year 10, the same total of $10,000 has been contributed to the account - but the total account value has grown to $16,289. That’s an increase of more than $6,200 over the actual amount contributed to the account.

Comparison: The impact of early investment contributions

When you compare the two scenarios, the total account funds after 10 years is $13,207 for Scenario A. For Scenario B, the total account funds grew to $16,289 over the same time period.

Over the course of 10 years, the higher initial contribution resulted in an additional $3,000 in account growth over the same ten-year period.

While not everyone is able to make a high initial contribution to a 529 account, the additional potential for account growth is considerable for those who are able to do so.

While not a direct comparison, consider a third scenario:

Scenario C: $10,000 contribution, plus a $1,000 annual contribution

In Year One, $10,000 is contributed to the account. With a 5% rate of return, that investment has grown to $10,500. In Year Two, another $1,000 is added to the account - bringing the total account value to $12,075 by the end of the second year, including 5% growth. This pattern continues through Year Ten.

At the end of Year 10, a total of $19,000 has been contributed to the account - and the total account value has grown to $27,867.

The combination of a higher initial investment plus ongoing contributions yields much higher results than either approach alone.

Contribution Limits

Individuals can contribute up to $14,000 (according to the 2014 IRS Tax Code) a year to any single 529 account without incurring a gift tax. However, the IRS allows people to contribute up to 5 years of yearly maximum donations at once ($70,000.) As long as no other contributions are made within the next 5 years, the gift tax will not be triggered.

For many grandparents, 529 plans are an effective tool for estate planning - plus, the tax- free growth potential of a 529 college savings plan allows you to maximize the impact of your gift. Consult with your tax adviser.

No matter how much or how little you plan to contribute to a 529 college savings plan, getting started is the most important part.

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