How a 529 Savings Plan Could Help Keep Your Child Out of Debt by Brian Fritzsche, CFASubmitted by Moller Financial Services on August 21st, 2018
How A 529 Savings Plan Could Help Keep Your Child Out Of Debt
A Daunting Challenge
As summer camps and family vacations wind down and students begin another school year, parents might now find themselves with a bit more free time to look ahead to the future. The skyrocketing cost of a college education is no longer headline news. With the average annual expense at a four-year private institution nearing $47,000 a year, parents must look for every break they can get when trying to save such an enormous sum to assist with their children’s schooling. Enter the 529 Savings Plan (not to be confused with prepaid tuition plans, another type of 529). These plans are administered by individual states but can provide tax advantages for parents on both the federal and state level. In a 2016 Fidelity study, households making over $30,000 annually responded that they were planning to cover an average of 70% of their child’s cost of college, yet only 41% are taking advantage of this tax gift from the government. The flexibility of the plan and potential access to years of tax-free compound investment growth often make it a no-brainer for any parent or grandparent hoping to cover some college costs for a child.
How It Works
When you contribute funds to a 529 savings plan, that money can be invested and grows tax-free until needed to pay for qualified educational expenses at any institution, regardless of the state you live in or location of the school. These include tuition, fees, books, room and board, and supplies for a full-time student. Some states will even allow you to deduct annual 529 contributions from taxable income on the state return. An account can be opened by almost anyone for any beneficiary and currently the only contribution limit is a $450,000 total account balance maximum for the Illinois plan. The investment management is fairly hands-off for the account owner; most plans will have you select a fund based on the beneficiary’s age and then automatically adjust to a more conservative allocation as the child approaches college. The contributions are considered a gift to the designated beneficiary (future student), so each person can only give $15,000 per year to each student before needing to file a gift tax return. However, it is allowable to contribute five years of gifts up front to a 529 savings plan, so a married couple could put in up to $150,000 (5 years x 2 parents x $15,000 annual gift exclusion) to jump-start the investment growth as long as they weren’t planning to gift any more to that child over the next five years. In addition, 529 plan assets are removed from the contributor’s gross estate, which makes the 529 savings plan a potential estate planning tool for some parents while still leaving them in control of the funds.
A lot of parents might wonder what happens to their savings plan if the designated beneficiary ends up not needing the funds saved in the 529 account. This could happen if the child earns a scholarship, graduates faster than anticipated, or if the account ends up being overfunded. The 529 savings account in that beneficiary’s name can easily be transferred to another family member, including siblings, children, nieces, nephews, and first cousins, and there is no deadline for the use of the funds to pay qualified expenses. You can also take a penalty-free distribution of any scholarship amounts awarded to the account beneficiary (although you will owe income tax on the investment earnings portion of that amount).
The Tax Cuts and Jobs Act of 2017 added K-12 tuition and expenses up to $10,000 per year per child to the list of qualified expenses for a 529 savings plan. Each state must also decide whether they will expand this definition in the same manner. In general, it is advisable to wait until college to spend the 529 plan funds, as the longer you can wait to use the money, the more you can take advantage of tax-free compound investment growth available in the plan.
If you do need to take a withdrawal from the plan that is not for a qualified expense, you will have to pay income tax and a 10% penalty on the growth of the investments. Another potential disadvantage is that the IRS only allows the investment allocation in a 529 savings plan to be changed twice a year. For nearly every parent, however, the investment selections will not need to be altered that frequently. In most cases, the pros definitely outweigh the cons.
A Great Savings Option
Even as college tuition nears seemingly astronomical levels, parents who are able to plan ahead and save early and often are at a distinct advantage over those playing catchup later in their child’s life. If college saving is one of your financial goals, the 529 savings plan offers tax-advantaged investment growth without any income limits that might also reduce your state income tax burden. Please feel free to contact us if you would like to discuss any higher education savings strategies in further detail. Have a great school year!