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Consumer Article February 2019: Make the Most of the 529 Plan — for College and Maybe Before, Too

Make the Most of the 529 Plan — for College and Maybe Before, Too

College can be expensive. And as anyone who has contemplated funding a child’s college education likely is well aware, it’s not getting any cheaper. Which is why it’s critical to consider taking advantage of any and all programs that make paying for a child’s education less burdensome financially, including, in particular, what’s known as the Section 529 college savings plan.

The 529 plan is a tax-favored vehicle established by the U.S. government that parents (or anyone, for that matter) can open and contribute to on behalf of a child to fund that child’s college education. For many families, it has become an indispensable tool for managing the college costs that have been escalating at a rate well beyond inflation over the past decade and beyond. Indeed, according to the College Board, in-state tuition and fees at public four-year institutions increased at an average rate of 3.1 percent annually above inflation between 2008-09 and 2018-19.

With a 529 plan, the person wishing to initiate a plan on a child’s behalf (typically the parents of the child, although anyone may open a 529 account on a child’s behalf, including grandparents, other relatives, even friends) must first select a state plan. All 50 states currently offer some type of 529 plan. After choosing a particular state’s 529 plan, the plan owner then has latitude to choose the kind of account in which the savings will reside, from a mutual fund-type of account oriented more aggressively toward growth via investments in vehicles linked to the stock market, to more conservative money market-type accounts with a fixed return. Once the account is open, contributions on behalf of the student — the account beneficiary — can begin.

Much of the appeal of 529 plans lies in the tax breaks they provide. Not only may contributions to a 529 earn the contributor a state income tax break (many states offer income tax deductions for 529 contributions; deduction amounts vary by state), any withdrawals from the account, including earnings as well as principal, come out federal-income-tax-free, provided they are used for qualified education expenses: tuition, books, room and board, school supplies, etc. Withdrawals can be used for qualified expenses at any eligible college or university in any state, and at some schools abroad.

“Basically, your money grows tax-free [inside the 529], and when it’s withdrawn and used for college, that money won’t be taxed,” explains CERTIFIED FINANCIAL PLANNER™ (CFP®) professional and FPA member David R. Silversmith, CPA, senior accountant at Fulvio & Associates in New York City.

As compelling as these tax advantages can be, and as daunting as the college price tag may seem, the 529 remains largely overlooked. A 2018 study by financial services firm Edward Jones found that 71 percent of Americans do not know what a 529 plan is.

Even those in the know may not be familiar with certain nuances that could help them get the most out of a 529 plan. Here are some suggestions to help you maximize the program’s benefits:

Shop to find the best match. Not all state 529 plans are created equal. Some offer more account options in which to invest. Some plans perform better than others. Some plans and accounts charge lower investment fees than others. And of course, some in-state plans carry state income tax benefits. All these are factors to weigh in evaluating which state’s plan ultimately is likely to deliver the best value. The website SavingforCollege.com offers a list of states offering 529 income tax deductions, along with rankings and side-by-side comparisons of state 529 plans in such key areas as fund performance and fees.

For help evaluating your plan options, seek the guidance of a financial planner. To find one near you, visit the Financial Planning Association’s searchable database of CFP® professionals at www.PlannerSearch.org.

Choose a 529 account that’s appropriate to your risk profile. Most states offer a range of plans, each tailored to investment horizon (based on the beneficiary’s age and proximity to college), goals and other factors. Does it make sense to take more investment risk in exchange for higher growth potential, or if college is looming close, should you invest more conservatively in a fixed-income account with less upside potential but a guaranteed rate of return? Here’s another instance where advice from a financial professional with 529 expertise can be invaluable. 

If you choose your home state’s 529 plan, do your best to take full advantage of the state income tax break, if it’s offered. In certain states, the state income tax credit for 529 contributions kicks in only after reaching a certain threshold contribution level. If that’s the case, “you want to at least contribute enough to get that benefit,” says Silversmith. On the other hand, he adds, if your state does not offer a state tax deduction for 529 contributions, then you want to shop around for plans in other states, basing your selection more on factors such as plan performance and fees. 

Who’s next in line? With a 529, the account owner may switch the account beneficiary. So if a beneficiary for whatever reason does not use the funds for college (or for earlier schooling — see below for details on this new option), a new beneficiary, such as a sibling of the original beneficiary, can be named. If a student receives a scholarship, he or she may withdraw the amount of tuition without a 10 percent early withdrawal penalty. However, the increase in value is subject to income tax. 

Let grandparents, other family members and loved ones know they can contribute. Anyone can contribute to a 529 on behalf of a particular beneficiary. If, for example, a grandparent wants to contribute to a grandchild’s 529, they could contribute directly to an account that has already been established (such as by the child’s parents), or they could set up a separate new account to which to contribute on the child’s behalf (one child can be the beneficiary of more than one 529 account). If the grandparent lives in a state that offers a state income tax credit for 529 contributions, they may want to consider opening an account in their home state to take advantage of the state tax credit.

Manage 529 contributions with the gift tax in mind. All contributions to 529 plans are considered present interest gifts and qualify for the annual federal gift tax exclusion. A person can contribute up to $15,000 per year per beneficiary without incurring federal gift tax. There’s also the so-called “five-year election,” where a person can contribute as much as $75,000 lump sum to a 529 plan without incurring gift taxes, provided the contribution is claimed over a five-year period. This option typically is used as part of a broader estate planning strategy, often by grandparents of the beneficiary, as a means to shelter assets from estate taxes.

Exercise the freedom to choose. Participation in a certain state’s 529 plan doesn’t mean the student has to attend school in that state. Money in a 529 can be used to fund school in any state as well as many universities overseas. Say you live in Iowa but are participating in New York’s 529 plan. You can use your 529 money to pay for the beneficiary to attend an accredited school in Oregon, for example, or in any other state for that matter. 

Beware early withdrawal penalties. The owner of a 529 account (not the beneficiary) can withdraw money from the account at any point, but in doing so, must pay income taxes on any earnings, plus a 10% penalty on those earnings if the money is not used for qualified education expenses.

Consider capitalizing on a new twist. As a result of federal tax legislation that took hold in 2018, the 529 isn’t just for higher education anymore. Funds in a 529 plan now can be used to pay for up to $10,000 of tuition expenses per year, per student, for enrollment at an elementary, middle or high school. Anything above $10,000 is subject to income tax and a 10% federal penalty. It’s important to note that certain states have moved to override the new federal policy and now prohibit the use of 529 funds for schooling other than college. So check with your state before trying to take advantage of the policy.

February 2019 — This column is provided by the Financial Planning Association® (FPA®) and FPA of San Diego, the principal membership organization for Certified Financial PlannerTM professionals. FPA seeks to elevate a profession that transforms lives through the power of financial planning. Through a collaborative effort to provide members with tools and resources for professional education, business support, advocacy and community, FPA is the indispensable resource in the advancement of today’s CFP® professional. Please credit FPA of San Diego if you use this column in whole or in part. https://fpasandiego.org/index.php

The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION.  The marks may not be used without written permission from the Financial Planning Association.