529 Plans – What Are They and Why Should I Use Them?

One thing I am not carrying forward are 529 college savings balances.  Over many years I contributed, monitored, adjusted - and yes withdrew.  As the final balance is withdrawn and the full benefits gleaned, I thought I would share the different features and benefits of these accounts.  I strongly encourage their use for most circumstances.

What is a 529 plan?

A 529 plan is a tax advantaged plan to encourage saving for educational costs.  The plans are typically sponsored by states and are authorized by Section 529 of the Internal Revenue Code – thus their name.  The concept is to begin saving early in these plans and, provided funds are used for qualified educational expenses, the earnings grow tax-free at both Federal and State level.  For some states there is also a state tax (not Federal) deduction on contributions (up to limits).

Are There Different Types of 529 plans?

There are two types of 529 plans.  I will mention the key features of each plan here, then expand upon 529 Savings Plans in the rest of the blog.

1. 529 Education Savings Plans
   • Covers tuition and fees PLUS room and board at any accredited college or university, public or private, throughout the US (not just the state where 529 plan set up)
   • Can use up to $10,000/year for public or private elementary or secondary school
   • Can use up to $10,000 (one-time, not per year) to repay student loans; can also use up to $10,000 for each of beneficiary’s siblings
   • Savings are made to an investment account with defined investment choices including “target age” funds, mutual funds and/or ETFs
   • All earnings growth is tax free – both federal and state - if used for qualified educational expenses
   • Owner of account takes full responsibility for investments; no guarantees on returns and could lose money
   • College inflation also borne by the owner of these accounts
2. 529 Prepaid Tuition Plans
   • Covers tuition and fees only; NOT room and board
   • Can NOT use for elementary or secondary school nor student loans
   • Sponsored by states (typically must be a resident) or college/university
   • Not all states offer these plans; IL currently NOT accepting new deposits
   • Savings go to purchase semester units at participating (i.e. in-state public schools) for future tuition; the cost of units is based on current tuition prices
   • If attend non-participating college (i.e. either private or out-state) there is typically a haircut to the value of units purchased (about 25% for IL plan)
   • Owner of account takes no investment risk or college tuition risk
   • However, are taking the credit risk of the state (if state budget can’t support program there is no Federal backing)

The rest of this blog post will focus on 529 Savings Plans unless noted.

Who is the owner of the account?

The owner of the account can be any adult (typically the parent or a relative), but it can only be in one person’s name.  For a couple, use the person who will likely handle most of the college finances since the provider can only speak to the owner.  Be aware any tax benefits accrue to the owner’s tax return.

Who is the beneficiary of a 529 and can I change them?

The beneficiary is the person the owner intends to provide funds to cover their qualified education costs.  Initially the beneficiary can be anyone with a valid Social Security number.  However, a new beneficiary needs to be a family member which for Illinois is defined as siblings, children, parents, in-laws and even first cousins.

Can I have just one 529 for the family and change beneficiaries as needed?

You can but I don’t recommend that for two main reasons:  1) the time when funds are needed will change quickly for each child; 2) if have two (or more!) children in college at once you will need to change beneficiaries each time want to withdraw to cover qualified expenses.

Do I have to attend a school in the same state as the 529 Plan?

No - for 529 Savings Plans it does not matter where the school is located.  It DOES matter for Pre-Paid Tuition Plans.  There are some foreign schools that qualify for use with 529 Savings Plans but I will not address those details.

What costs are included in “qualified educational expenses”?

Recall, 529 Pre-Paid Tuition Plans only cover tuition and mandatory fees while 529 Savings Plans cover that plus more.  Below are common expenses and whether covered for a Savings Plan.  See here for a related article.

Common qualified expenses for college

• • Tuition and fees (limited to $10k/year from K-12)
  • Books and supplies
  • Room and board
  • Computers and special needs equipment

NOT qualified expenses

• • Transportation and travel
  • Health insurance
  • Applications and testing fees

 

How do you tap the funds once start incurring expenses?

You must withdraw funds from the 529 Savings Plan account in the same calendar year (not academic) the cost is incurred.  The funds can be paid directly to the school or to reimburse the person paying the bills (either parent or student).  I personally established an ACH connection to my checking account for 529 withdrawals, then paid the institution or reimbursed the child for qualified expenses.  For Pre-Paid Tuition Plans the funds are typically paid directly to the school.

When should I start to save and how much is needed?

It depends, but a lot more than you might think.  A few things to keep in mind.

• • Start now, even if a smaller amount; don’t let large amounts paralyze you
  • Your income will likely grow over time so also assume contributions increase over the years
  • Decide if plan to cover the full or a portion of the cost, with the student responsible for rest
  • Use a 22-year saving horizon; you don’t need to pre-fund all on the first day of college
  • While some costs at home may be reduced after leave for college, it is not a direct offset for room/board which includes rent

Look at college websites for cost of attendance, including room/board, based on current prices.  Let’s look at an Illinois resident who wants to fully fund a 4-year, $33,600/year education at U of I (tuition, room/board, fees at today’s prices), assume costs increase 4%/year, and portfolio returns of 5%/year (higher in early years, less as college approaches).  Here are the monthly contributions needed under different scenarios.  I like the third bullet but be sure to increase each year after getting a raise!

• • Flat contributions and fully fund at 18th year = $760/month
  • Stretched out over full 22 years of college = $675/month
  • Contributions grow 3%/year and fund over 22 years = $510/month.

I’ve gotten this far and you haven’t described taxes or investments in detail.  Let’s go!

There are two key tax benefits in a 529 Savings Plan:  1) earnings on investments grow tax-free at federal and state level; 2) some states allow contributions to be deducted on the state tax return.  Note the deductible contributions DO NOT apply at the Federal level.

Each state (with an income tax) has their own rules on whether contributions are deductible and if an annual limit.  A few examples:

• • IL allows annual deductions up to $10,000 for single filer; $20,000 joint return regardless of number of children
  • CO has no annual limit on amount of contributions deductible
  • VA allows deductions of $4,000 per account per year with unlimited carryforward
  • CA doesn’t allow a state deduction

What is the tax benefit in dollar terms?

The table below shows the ending balance after 18 years for three different Illinois residents who save a steady $760/month, earn 5% on portfolio, capital gains tax rate of 15% Fed and 4.95% IL, and never sells anything until end of 18^th year when pay capital gains tax.

The “529 Plan no deduct” could be someone who forgot to deduct contributions on their state return or who lives in a state with no income tax.  Remember you still get the advantage of avoiding federal tax on investment gains.

What are the investment options?

Most 529 Savings Plans offer either an age-based portfolio selection (similar to retirement target-date funds) or individual mutual funds or exchange-traded funds to construct your own portfolio.  One key difference with investing a 529 Savings Plan vs. your own retirement plan is the time horizon (how soon money needed) changes very quickly!  Retirement may be 25 or more years away when start saving for college and money is withdrawn over many years.  A 529 Savings Plan will be needed within 18 years (if start immediately) and all funds needed over 4 years.  And did I tell you they grow up quickly?

How often can you rebalance?

To encourage the SAVING part in the 529 Savings Plans, you are only allowed two rebalances per year.  In addition, the portfolio can be tweaked on the margins by directing new contributions or withdrawals to/from particular funds.  Alternatively, the age-based investment options handle the rebalancing for you as your child approaches college.

What are the fees?

The fees will vary by state plan and whether you set up and manage the 529 Savings Plan on your own or have a professional assist.  Fees are typically assessed as a % of account balance. The table below is for Illinois Bright Start program.  The state typically charges a fee to administer the program.  Then an additional fee is assessed depending on the investment choices.

What if I don’t use the funds for educational expenses – either they don’t attend college or due to a scholarship?

If the funds are not immediately needed by the beneficiary you have a few different options.

1. Change beneficiary to another family member who can utilize the educational benefits.
2. Leave the funds in the account for that beneficiary who can use the funds later for themselves or other family members – even the next generation.
3. Withdraw the funds.  The earnings portion (not contributions) will be subject to Federal and State taxes plus a 10% penalty.  You will also likely need to pay back any state deduction benefits.

Regarding scholarships, funds can be withdrawn penalty free that match the amount of scholarship received.  You will have to pay income tax on the earnings portion however, but you would be no worse off had you not used the 529.

Does a 529 account impact potential financial aid?

It depends on the owner of the 529 account.  Also note the Free Application for Federal Student Aid (FAFSA) process has many moving parts but the main driver is income, not assets.

The most advantageous is if a parent (or student) is owner.  The 529 account is then considered a “parent asset” and only 5.6% of the balance is counted as assets in FAFSA.  The withdrawals taken to cover costs are NOT included as income for FAFSA.

If a grandparent or other relative is the owner, the 529 balance is NOT an asset on the parent’s FAFSA.  However, withdrawals taken must be counted as income that year.  One strategy, if possible, is to delay any withdrawal from grandparent’s 529 until the January or later of the sophomore year.  This is because FAFSA uses the prior-prior calendar year of taxable income.

Do I have to worry about annual gift amounts?

Yes.  Because amounts contributed to a 529 incur a cost if not used as intended, it is considered a gift to the stated beneficiary.  With the current annual gift exclusion of $16,000 and gift-splitting with a couple, a married couple could contribute $32,000 each year to each child.  This is another reason to have an account for each child listed as beneficiary.

There is an exception with 529 Plans called the 5-year election.  This allows an annual contribution that exceeds the limit to be treated as if it occurred over 5-years, provided that gifts in future years aren’t done pushing them over the annual amount each year.  You also need to select this election on Gift Tax Return Form 709.

Are you done yet?

I am.  This has turned into a long thesis paper.  There are many features of 529 Plans and hopefully once you understand all the benefits, you will make use of these accounts to help cover educational costs for our future leaders.

Posted by Kirk, a fee-only financial advisor who looks at your complete financial picture through the lens of a multi-disciplined, credentialed professional. www.pvwealthmgt.com