529 Plans For College Savings
College is expensive, and tuition only seems to go up. American families looking to pay for a college education have a variety of choices when it comes to the best way to save for the cost of a diploma. As a fee-only, fiduciary financial planner, I love giving people objective advice about how to save for a very meaningful goal like college, and I feel strongly 529 plans are unparalleled when it comes to a college savings vehicle.
Section 529 plans offer unique flexibility to aid families, and family financial dynamics, to pay for college. There’s no income limit on eligibility to use them, families can change the beneficiaries on the accounts at will, and the money can be withdrawn in the event the student receives a scholarship.
529 plans also offer tax advantages in three segments of the 529 life cycle: deposit, interim, and withdrawal. Not to mention the ability to “super-fund” the account with up to five years worth of contributions in one single year.
Some people may be concerned that 529 plans will impact financial aid, but if the account is properly titled, the assets in it should only reduce the student’s financial aid by a maximum of 5.64%. By comparison, the investment growth one could expect over a few decades while saving for college should more than offset any reduction in financial aid.
Why You Should Consider 529 Plans For Your College Savings Strategy
One of the best things about 529 plans is their eligibility to use one. There are no limits on income, making them accessible to anybody that wants to utilize them. 529 plans also offer the ability for families with multiple children, or ambitious family members, to pursue education and exhaust the funds. The beneficiary on the account can be changed at will, allowing Susie to attend school, and Susie’s parents to take any leftover money in the 529 plan and change the beneficiary to Johnny. This offers a great advantage over other college savings vehicles (like a UTMA/UGMA), that don’t allow parents to change the beneficiary. Furthermore, the UTMA/UGMA account eventually becomes the child’s money once they reach the age of majority, and that means they can utilize the money for whatever they want. Terrifying, right? The 529 plan doesn’t face this problem, because the account owner retains control. If there’s money left over after Susie wraps up school and Grandmom wants to get a Master’s degree in Spanish Literature, she can use the funds too (Grandmom always did love Spanish Lit). Not to mention the 2017 Tax Cuts and Jobs Act expanded 529 plans’ considerably, now allowing up to $10,000/year to be utilized for K-12 education as well. All of this is to say that with the increases in tuition, and the ways 529 funds can be spent, there’s no shortage of opportunities for someone in the family to benefit from having a 529 plan.
Let’s suppose for a moment that your child receives a scholarship. Every parent’s dream. Fortunately, the 529 plan is happy for you too and will allow parents to make a withdrawal from the 529 plan up to the tax-free amount of the scholarship without penalty. You’ll still owe taxes on any gains, but scholarships are an exception to the 10% penalty normally applied to non-qualified education expenses. It is important to note the taxes are only due on any earnings the account generated since your contributions were made with after-tax dollars. This feature, coupled with the ability to change the beneficiary on the account anyway, should assuage parents’ concerns that a scholarship is anything but a blessing. On the contrary, some parents also express concern that if their children don’t go to college, the funds would be wasted. Not to worry, the funds always can be withdrawn for non-qualified education expenses. Taxes on the earnings and a 10% penalty would be due, but saving for college and not going to college beats not saving and trying to figure out how to pay for it.
All of this is really predicated on the fact that college tuition costs have been a runaway freight train for most Americans. According to the Department of Education’s National Center for Education Statistics, “Between 2005–06 and 2015–16, prices for undergraduate tuition, fees, room, and board at public institutions rose 34 percent, and prices at private nonprofit institutions rose 26 percent, after adjustment for inflation.” ZOIKS. That is a very large increase in just ten years. So, for most families, paying for the cost of tuition out of pocket will be impossible, and the 529 plan is here to save the day again. Plans can be established for the child as soon as they have a social security number and a name, and let the magic of compound interest do the heavy lifting. Regular contributions over 18+ years into an age-based portfolio should help parents combat the increase in tuition, maybe not entirely, but far more so than if the parents were trying to save their way to the price tag for tuition. The age-based portfolios are a wonderful development in 529 plans, akin to target-date funds in a 401(k) plan. The investment starts out more aggressive when the child is younger, and automatically sunsets into a more conservative allocation as they age and the parents get closer to the end of the time horizon before withdrawals.
How 529 Plans Work
Now that we’ve discussed the flexibility of 529 plans and why they should be utilized in theory, let’s dig into some of the mechanics about what makes 529 plans so special. Primarily, 529 plans are a tax-advantaged savings vehicle, only bested in their tax-awesomeness by Health Savings Accounts (HSA’s). 529 plans offer tax advantages at three different stages: contribution, interim, and withdrawal. Most states offer a tax deduction for contributions made to a 529 plan, which isn’t nearly as sexy as a federal deduction, but here in good ol’ Pennsylvania, for example, our state income tax is 3.07%. So, if we, as a couple make $100,000 but contribute $5,000 to little Mark’s 529 plan, our state income taxes are now based on $95,000 of income, instead of $100,000, and saves us $153.50 in PA state income tax. That’s the good news when you make contributions.
Now that the money is in the account, and you’ve selected your age-based portfolio, the money will grow tax-deferred. This is an important distinction between other accounts you could use for college savings, like a brokerage or savings account, that would likely be taxed every year on interest and gains. The taxes along the way would rob you, and your little scholar, of money that could have been used for education. Instead, 529 plans allow your funds to grow without being taxed every year and allow you to make tax-free withdrawals for qualified education expenses. That’s right, if you only use the funds for qualified education expenses, you won’t owe income or capital gains taxes on the funds. This is a tremendous advantage over investing funds on your own outside of the 529 plan. Imagine you contributed $50,000 into a brokerage account and bought a diversified portfolio. There would likely be some capital gains and interest every year, creating a tax bill. Let’s assume the $50,000 grew to be $75,000. The $25,000 capital gain would be taxed at 15% (or maybe as high as 20% depending on your bracket), effectively reducing the gain to only $21,250 after the tax bill is paid. The 529 plan allows us to realize the full $25,000 gain, so long as we utilize the funds for qualified education expenses. It literally pays (an extra $3,750 in this example) to use the 529 plan!
Tax-free growth isn’t the only tax advantage of 529’s either. As of this writing (2019), the annual gift-tax exclusion amount stands at $15,000. This means I can give you $15,000 and Uncle Sam doesn’t care. If I was married, as a household, we could give you $30,000 a year (you deserve it), and Uncle Sam still doesn’t care. This is relevant to 529 plans because anything over the annual exclusion amount would have to be reported as a gift, but 529 plans have a special provision that allows you to “superfund” them with up to five years worth of contributions in a single year. This means a single person could contribute up to $75,000 in one year, or a married couple could contribute up to $150,000 in one year, and still not eat up any of the gift tax exemption. That’s a story for another estate planning day, but it is worth mentioning that once the five years passes, the funds are out of the donor’s estate. The “superfunding” strategy is really about math, more than anything. Let’s say you had the means, as a couple, to contribute $150,000 to your new baby’s 529 plan the day she was worn. Let’s say that $150,000 earned 6% a year, every year until she was 18. That $150,000 would grow to be worth $428,150. Not bad, right? Instead, let’s suppose you are a normal person without $150,000 burning a hole in your pocket. You contribute a still-hard-to-do-for-most $10,000 a year for 15 years, and then let it ride for another three more until college starts. Still contributing $150,000, right? How much different could the end result be? Welp, the same $150,000 invested over time only amounts to $293,853. Making smaller contributions over time “cost” us about $135,000 in forsaken growth. This is the cruel math of smaller, periodic contributions. Even if it ends up being the same amount you contributed in the end, putting money to work faster usually works out better.
529 Plans And Financial Aid
The reality for most multi-child households in America is that a 529 plan will fall short for everyone’s tuition bills. The aforementioned increases in tuition will be difficult for most families to pay for, so the 529 plan should be considered a tool in the toolbox. The difference between what’s saved and the tab for the education will have to be made up elsewhere, and most families will look to some combination of loans, cash flow, and other savings. When it comes to financial aid, 529 plans do impact a student’s eligibility, and there is some nuance to just how much the 529 plan hurts them. For starters, 529 plans should probably never be held directly in the student’s name. There are some unique situations where that may not be the case, so as always, check with your tax professional. The Free Application for Federal Student Aid (FAFSA) understands parents don’t just go to work to pay for college. They allow for a certain amount of money within the household that won’t be counted towards a student’s Expected Family Contribution (EFC). Let’s suppose, for example, that parents had a 529 with $50,000 in it, but had an asset protection allowance of $15,000. The $35,000 above the asset protection allowance would count towards the EFC and could reduce the financial aid package by 5.64%, or $1,974. This small reduction in financial aid should be jumping and screaming off the page as small potatoes compared to the sweet, sweet tax-free withdrawals we discussed earlier. The 529 is still a great deal, even if it means it reduces your child’s financial aid a little bit. Just to keep beating the dead UTMA/UGMA horse, UTMA/UGMA accounts will reduce a child’s financial aid package by 20% as those are counted as a student’s asset and not treated as favorably by the FAFSA.
This presents a very interesting strategy for grandparents that want to make contributions to 529 plans. When the student files the FAFSA, the asset won’t show up on the application because it is owned by the grandparent. This is a good thing for financial aid purposes, but anything gained by “hiding” the assets with Pop-Pop would be more than lost when Pop-Pop takes distributions for tuition bills, for example. Those distributions would be treated as untaxed income to the student, thereby reducing eligibility for financial aid by 50% of the amount of the distribution. Eek. This all changed when the FAFSA started utilizing prior-prior year tax returns. This means 2019-2020 FAFSA applications would use tax data from 2017 for example. This would be (and should be) boring to most people, but not you, savvy college saver. This means that Pop-Pop can still hold a 529 plan for Junior, not have it impact Junior’s eligibility for financial aid as an asset, and wait to utilize the funds until after January 1st of Junior’s sophomore year of college. By sandbagging the use of his 529 funds, Pop-Pop will have insulated the tax return data from the all of the rest of Junior’s FAFSA applications! If Junior was a sophomore in 2019-2020, Pop-Pop would start taking distributions from his 529 on January 1st of 2020, and all they would never show up as untaxed income to Junior on his FAFSA because the remaining FAFSA applications he needs to file (2019-2020, 2020-2021, and 2021-2022) would be based on 2017, 2018, and 2019 tax returns. I know, I know. Take a moment to process this very exciting information. This strategy would require Junior’s parents to be able to pay for his education some other way until Pop-Pop can start helping in 2020, but it is a creative way to maximize Junior’s financial aid eligibility if Pop-Pop really wants to contribute to Junior’s education.
If Pop-Pop and, let’s say, Junior’s mom (great lady) both have 529 plans, the plot thickens. Pop-Pop could transfer money from his 529 to Junior’s mother’s 529 every year after the FAFSA is filed, and then she could spend the money on qualified education expenses. This would not reduce his Junior’s financial aid eligibility because it wouldn’t show up as income to him and it would be gone before it’d be considered a parental asset on the next FAFSA. Consult with your tax professional for additional guidance, especially if the parent and grandparents live in different states (states may get a little funny if they gave a tax deduction to one person and they shipped the funds off to someone in a different state).
If you’ve made it this far, I hope you’ll reach out and let me know if you found this to be a valuable resource for your quest for college savings information. Shoot me an e-mail at brendan@meaningfulwealthmanagment.com if I can clarify or expand on something for you.