Thoughts before Funding a 529 Plan

Roxanne Alexander

Roxanne Alexander, CAIA, CFP®, AIF®, ADPA® Senior Financial Advisor

The new tax law was amended to allow tax-free distributions of up to $10,000 per year from a 529 plan for elementary and high school costs starting in 2018. This is an added benefit and can be an advantageous tax break for parents starting to save for their young child’s education.

College costs have outpaced inflation. According to The College Board®, the average 2014-2015 tuition increase was 3.7 percent at private colleges and 2.9 percent at public universities. However, looking back at the last decade, the 10-year historical rate of increase has been approximately 5 percent.

529 Basics — Opening a regular savings account/custodial account for your child is an option, but this comes without the benefits of a 529 plan such as the tax-free growth on earnings if the funds are used for qualified college expenses. Deposits to a 529 plan up to $15,000 per individual per year ($30,000 for married couples filing jointly) will qualify for the annual gift tax exclusion (for 2018). You can also front-load your investment in a 529 plan with $75,000 ($150,000 if joint with your spouse) and use this toward your gift tax exemption for five years providing there have been no other gifts to that child — this is not possible for a regular savings/custodial account for your child (you would only be able to gift $30K jointly). By adding a large amount up front, you allow the lump sum to grow over a longer time horizon vs. making smaller contributions over time. Contributions to a 529 plan do not have to be reported on your federal tax return.

Contributions to a 529 plan are not tax deductible (although some states do offer tax benefits), but the earnings grow tax free and are not taxed if used to pay for education. Another advantage compared to a custodial account is control; the named beneficiary has no legal rights to the funds, so you can ensure the money will be used for education.

A 529 account owned by someone other than the parent (such as a grandparent) is not considered an asset for financial aid purposes. Also, the value of a 529 account is removed from your taxable estate, yet you retain full control over the account.

How to choose a 529 plan? Research the underlying expenses of the mutual funds and review the investment options available compared to other plans. The age-based models may be the easiest to manage as the plan shifts to more conservative investments as the student gets closer to college age. You can choose any state plan no matter where you live, but if you reside in a state that provides tax breaks for using your state plan, you would likely want to start there. For example, New York residents get tax benefits for using their state plan. Keep in mind that you have the ability to move your 529 to another provider, but only one rollover is permitted per twelve-month period.

How much to fund? The amount to contribute to a 529 plan depends on several assumptions such as whether your child will attend a public college or a private college, the returns during the investment time horizon, and future college inflation. Funding varies widely depending on what you would like to achieve and the assumptions involved — and of course there is no right answer. If the beneficiary does not go to college, you can transfer the 529 plan to a sibling in the future or to another family member such as a cousin or grandchild. If you don’t have any eligible family members, the worst-case scenario is that you would have to pay tax and a 10% penalty on the earnings to take the money out for another purpose. Withdrawals from a 529 plan that are not used for the beneficiary’s qualified education expenses are taxed and penalized (subject to a 10 percent federal penalty and taxed at the income tax rate of the person who receives the withdrawal). If the beneficiary gets a scholarship, then the penalty is waived.

Avoid overfunding the 529 if possible as “qualified education expenses” do not cover all expenses related to college. Qualified expenses include tuition, on-campus room and board, books and supplies, computers, and related equipment. It may also make sense to save otherwise for expenses such as travel, cars/transportation costs, insurance, sports or club dues, and off-campus housing, etc., which are not considered qualified expenses but can easily add up.

Considerations if you have more than one child — If you have several children, it may make sense to fully fund the first plan for the oldest child and if the funds are not used, they can be transferred to the next child in line. You probably want to avoid fully funding all the plans in the event one child does not end up going to college, gets a scholarship, or starts a business. Some schools and some trade schools/programs do not qualify for 529 funds (for example, if a grandchild wants to go to a specific acting or cooking school). You can find out if your school qualifies by using this link: http://www.savingforcollege.com/eligible_institutions/.

http://www.savingforcollege.com/tutorial101/the_real_cost_of_higher_education.php

https://www.npr.org/sections/ed/2018/01/08/575167214/congress-changed-529-college-savings-plans-and-now-states-are-nervous

Feel free to contact Roxanne Alexander with any questions by phone 305.448.8882 ext. 236 or email: RAlexander@EK-FF.com