Over the years, our team of advisors has built literally hundreds of financial plans for our clients. And in many of these plans our client has wanted to include saving for college for a child, a grandchild, another family member or a close friend.
New clients who haven’t yet started saving for college often ask us, “Is a 529 plan a good way to save for college?” New clients who already have a 529 plan account established similarly ask us, “Am I using the best 529 account to save for college?”
Let’s start by reviewing what 529 plans are. Then, we’ll explore how 529 plan accounts can be used to save for qualified education expenses. And finally, we’ll list some of the most important factors to consider when picking a 529 plan to save for college.
What’s a 529 Plan?
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. They are formally known as “qualified tuition plans”.
529 plans are sponsored by states, state agencies, or educational institutions, and are authorized by Section 529 of the Internal Revenue Code. Section 529 was added to the IRC in 1996.
There are two types of 529 plans: prepaid tuition plans and education savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a number of private colleges and universities sponsor prepaid tuition plans.
Using a 529 Plan to Save for Education Expenses
Education savings plans let you open an investment account to save for the account beneficiary’s future qualified education expenses – more on what qualifies, below. Withdrawals from education savings plan accounts can generally be used at any college or university, including sometimes at non-US colleges and universities. Education savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at any public, private or religious elementary or secondary school.
Prepaid tuition plans allow you to pre-pay future college costs today. These plans aren’t nearly as popular as the savings plans. There are far fewer of them, and most have residency requirements. From a tax perspective they offer the same benefits as savings plans. But they don’t cover as many costs as savings plans do.
For all these reasons, our focus here will be on the more popular and more flexible savings plans.
Account Ownership
Typically, a parent or grandparent is the owner of a 529 plan account, and the student is the account’s beneficiary. As the account owner, you can change the beneficiary of the account at any time. You might change beneficiary if one of your kids ends up receiving a full scholarship for college, and doesn’t need the savings you’ve accumulated in their account, or if they don’t go to college at all.
We’re sometimes asked by grandparents if they should open their own 529 plan account for a grandchild, or simply contribute to an existing account set up by the grandchild’s parents. The answer is, it depends. If you own the account, you control who the beneficiary is, and when distributions will be made. If you contribute to someone else’s 529 account, you don’t have those responsibilities, but you also lose control over your contributions. Only you can determine what’s the best option.
Funding an Account
There’s no limit on how much you can contribute to a 529 plan account in any given year. And while 529 plans do limit the total amount that can be contributed to an account, these limits are very high. For example, at the present time Utah’s 529 plan will accept contributions until an account balance reaches $510,000.
Contributions to 529 plan accounts are considered gifts from the contributor to the account beneficiary for tax purposes. In 2021, you can make gifts totaling up to $15,000 per individual and qualify for the annual gift tax exclusion. Remember that for gift tax purposes, it’s the gift giver who may potentially need to file a gift tax form with the IRS, and not the gift recipient.
This means if that if you and your spouse have three children (or grandchildren), you can jointly give $90,000 without any gift tax consequences: $15,000 each, or $30,000 together, to each of your three (grand)children, for a total of $90,000.
What if your total gifts to one individual will total more than $15,000 this year? Well, then the excess amount above $15,000 may count against your lifetime estate and gift tax exemption and will have to be reported to the IRS on Form 709 when you file your taxes.
However, 529 plans feature an additional benefit that makes it possible to “superfund” an account, and that also makes them a great estate planning tool. Legally, you’re permitted to contribute up to 5 years’ worth of gifts in one lump sum, and then treat the contribution as though it will be spread out over a 5-year period. How does that work?
Using our earlier example, you and your spouse could give all three of your (grand)children $150,000 each in one lump sum, without any gift tax consequences: 5 years x $15,000 per year, or $75,000 from you and $75,000 from your spouse, to each (grand)child. You’d need to report the 5-year election to the IRS on Form 709 for each of the five years.
Taxes
The contributions that you make to a 529 plan account are made with after-tax dollars, much like a Roth IRA retirement account. Many states offer a tax benefit for contributing to a 529 plan, though there may be restrictions or requirements to receive the benefit, such as investing in your home state’s plan. For example, Oregon residents are eligible to receive a $300 tax credit (if they file jointly, or $150 if they file singly) on contributions to an Oregon 529 plan.
The biggest tax benefit, though, is that earnings in your 529 plan account grow tax-free. The longer your money is invested, the more time it has to grow and the greater the tax benefits.
And, subject to some conditions, account withdrawals for qualified higher education expenses or tuition for elementary or secondary schools are free from income tax, too. More on this below.
However, if the account withdrawal isn’t used for qualified higher education expenses or tuition for elementary or secondary schools, it will be subject to state and federal income taxes and an additional 10% federal tax penalty on the earnings withdrawn.
Paying for School
When it comes time to pay for school, if you use the dollars you withdraw for “qualified education expenses”, the distribution won’t be subject to federal income tax. In most cases, qualified 529 plan distributions are also exempt from state income tax, though a few states have unique rules regarding taxation of 529 plan distributions. You should consult your tax professional or financial advisor for guidance specific to your circumstances.
As noted above, the tax code was changed in 2018 to expand the definition of qualified higher education expenses to include up to $10,000 per year tuition at eligible K-12 schools.
Unfortunately, not all states conform to the new federal tax law. As present, more than a dozen states consider 529 plan distributions used to pay for K-12 tuition to be non-qualified, meaning that the earnings portion of the withdrawal is subject to state income tax. Again, you should consult your tax professional or financial advisor for guidance specific to your circumstances.
What Can You Pay For?
For college, university and other eligible post-secondary educational institutions, “qualified education expenses” include tuition, fees, books, supplies, equipment, computers and sometimes room and board. As noted above, the IRS also allows tax-free withdrawals of up to $10,000 per year, per beneficiary to pay for tuition expenses at private, public and religious K-12 schools.
Tax-free distributions may also be used to repay federal and private student loans.
Picking a Great 529 Plan
Given that there are so many 529 plans available, how should you go about picking the best one to use? Here are the most important factors we think you should consider when making your decision.
Tax Benefits
If you live in a state that offers its residents a tax break for using their home state plan, you should definitely include it on your short list. California and Washington don’t offer their residents any tax benefits for using their home state plans, while Oregon offers a small tax credit, as noted previously.
But you should also put the potential tax break into context. For example, if you live in Oregon and you plan to contribute, say, $75,000 to your child’s 529 plan in one lump sum, how important is the $150-300 tax credit, given the plan’s shortcomings?
Investment Options
At Springwater, we’re students of the science of investing. So, we understand that the same things that matter when building a portfolio for retirement matter when saving for college.
A great plan will allow you to create a custom allocation – or mix of mutual funds – with exposure to a wide range of asset classes, including US, international and emerging markets stocks, small cap and large cap stocks, growth and value stocks, bonds, real estate and cash equivalents. Pre-mixed allocations created by the plan’s investment manager – sometimes called “years to college”, “age-based”, or “dynamic” portfolios – aren’t necessarily a bad thing, but the ability to create your own investment mix is preferable.
Fees and Expenses
Smart investors know that they can’t control what the market will do, but also that they can control one important factor that impacts their returns – fees and expenses.
Fees and expenses also play an important role when selecting a great 529 plan. Look for a plan that has low administrative and operational expenses, since costs directly impact the growth of your account over time. And, perhaps even more importantly, pay close attention to the expense ratios of the mutual funds offered in a plan’s investment menu. As the famous investor John Bogle once said, “In investing, you get what you don’t pay for”. Fund management companies like Vanguard, Dimensional Funds, and BlackRock not only deliver excellent long-term investment results, but they do so at a relatively low cost.
Moving from a Bad Plan to a Great Plan
What if you’re reading this, and realize that you’re invested in a “meh” plan? What can you do? Well, there’s good news! The IRS will allow an account owner to transfer money from one 529 plan to another plan for the same beneficiary without any federal tax consequences, as long as it’s done within 60 days. And, you can only complete one such “rollover” every 12 months for the same beneficiary.
Importantly, though, not all states treat such distributions the same from a tax perspective. A number of states actually consider a distribution used to fund another state’s plan to be “non-qualified” and subject to state income taxes on the earnings portion of the distribution. And, if the 529 plan account owner previously claimed a state income tax deduction or credit, the state income tax benefits attributable to the outgoing rollover will also be subject to recapture.
Looking for Guidance?
If you need help with planning for education expenses, consider working with a Certified Financial Planner™ (CFP®). Advisors who hold this designation have met rigorous educational, experience and ethics requirements.
If you’re looking for help with planning and investing for education expenses, contact us today to see how our team at Springwater Wealth can help you.