Today we are going back to school to discuss an often-misunderstood topic. What is the best way to save for a child’s education? I hope we can all agree that more education is always a good thing. This is a hill we are willing to die on. It is also fair to say that there are a lot of ways to get more education. From hands on training and apprenticeships to trade schools and universities. Some are paid for in the form of lower wages while you learn the necessary skills. Others have a more direct cost by way of tuition. Today we are going to focus on saving to pay the direct costs of tuition from trade schools, colleges, and universities.
There are a dozen different ways you can save for a child’s education including custodial accounts like the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA), prepaid tuition plans, Coverdell Education Savings Accounts, 529 College Savings Plans, and even utilizing your Roth IRA. In order to avoid being another two-minute highlight that leaves more questions than answers, we will focus on one of our favorite educational savings tools, the 529 Savings Plan. Every option has its place and in matters of finance “it depends” rules large. However, for a large number of savers the 529 Plan is a great fit.
History of the 529 Plan
The origins of the 529 plan came from the State of Michigan in the mid-eighties. To help alleviate fears parents had about the rising cost of tuition the state created a state-run prepaid tuition program, called the Michigan Education Trust (MET). This allowed parents a way to address helping their kids pay for school without being affected by future rising costs for in-state schools. Soon other states around the country followed suit.
A series of court battles over the taxation of the investment gains in these trusts ensued with Michigan eventually coming out on top in 1994. Subsequent legislation from 1996 to 2001 authorized qualified state tuition programs to have tax-deferred savings, tax-free qualified distributions, an expansion of what expenses qualified, and the ability to save for any future education costs, rather than pre-pay for a select group of in-state Colleges and Universities.
Today both pre-paid tuition plans (buying credits for school at today’s cost) and education savings plans (tax advantaged saving for future school costs) are both offered in most states. While pre-paid tuition plans still exist, the 529 education savings plans are more popular since there is no restriction on where kids go to school, and they can be invested in funds meant to keep up with the rising cost of education.
Who can benefit from a 529 Plan?
Anyone really. There are no age or income restrictions on 529 savings plans. A parent could use the funds to pay for their 18–year–old child to go to college or for themselves to go back to graduate school. One account can actually be used for both, just not at the same time.
Due to a unique 529 plan rule you have one consistent owner, but the beneficiary can be changed at any time. That means unused funds can be passed on to the beneficiary’s parents, siblings, cousins, children, spouse, and even in-laws. We see a lot of families with multiple children who believe not all of them will want to continue their education. This mitigates that issue.
Who can contribute to a 529 Plan?
Parents remain the number one contributor, with grandparents and aunts / uncles coming in second and third respectively. There are no limitations on who can establish a 529 plan, or who can contribute, but the most common scenario is the parents owning the account and other family members contributing to it.
One planning opportunity regarding this flexibility is to have the grandparents open an account for the benefit of their grandchild so that the money is not counted when applying for student aid. The catch is that once the money is withdrawn it will count as income for the beneficiary, so we believe it should be used to pay towards the end of school. This is because FAFSA uses the prior-prior year for income / tax information. If the grandparents can wait until after January 1 of the beneficiary’s sophomore year to take a distribution, it will not be pulled into the FAFSA calculations if the student graduates in four years. This needs to be planned because if the student will graduate in five years, the grandparents can wait until January 1 of the junior year to take the distribution.
What can a 529 Plan be used for?
529 Plans are savings vehicles, like an IRA or brokerage account, but with the specific purpose of using the funds to pay for certain types of qualified educational expenses. A qualified educational expense is defined by the IRS as “amounts paid for tuition, fees and other related expense for an eligible student that are required for enrollment or attendance at an eligible educational institution.” For example, a computer can be a qualified expense if it is used primarily for school by the beneficiary. However, if it has updated graphics cards or hardware for computer gaming, probably not. This generally falls under the language that “books, supplies, and equipment students need for a course of study are included in qualified expenses even if they are not paid to the school”.
Following the TCJA legislation that passed in December of 2017 529 plans can now be used to pay tuition costs for private elementary or high schools of up to $10,000 per year. Unfortunately, this isn’t a black and white issue. Many of the states have language written into law providing tax incentives to contribute to their state’s plan. This language does NOT contain the new qualifying expense in the wording which means that a state could technically recapture any state tax benefits if they are used for this purpose. Many experts believe that this wouldn’t ever happen, and it is just a matter of state law having to catch up with federal law, but it is worth mentioning so you can check with your state’s plan.
In addition to four-year colleges and universities, tuition costs for other educational institutions may count as well. Any school participating in the Federal Student Aid Program should qualify and can be found by searching the Federal School Code List. A quick search includes culinary, barber, and cosmetology schools just to name a few. While we may commonly refer to these as college savings plans, just remember that the application is broader.
It is also helpful to know what it can’t be used for. It can’t be used for insurance, medical expenses, transportation, or living expenses. It also can’t be used to pay back student loans. It can be used towards room and board, but the claimed expense can’t exceed the actual amount charged if the student was living in housing operated by the school or the allowance used in the school’s cost of attendance for federal financial aid calculations.
What are the tax incentives for 529 Plan contributions?
At the Federal level 529 Plans allow for tax deferred savings and tax–free distributions (when used for qualifying expenses), but nothing directed towards contributions. The states, on the other hand, have created a patchwork of incentives tied to contributions that depend on where you live (see map here).
For example, in Indiana, you can receive a 20% tax credit for your annual contribution up to a maximum of $1,000. Any Indiana state resident making a $5,000 contribution annually would qualify for the maximum $1,000 state tax credit, regardless of who owns the account. Conversely, other states may have deductions instead of credits, only be available to the account owner, or have no tax incentive at all. You have to do your homework to know what you might be getting.
What do I do with my 529 Plan if my child doesn’t need it?
The answer depends on why it isn’t needed. If it’s because they don’t plan to attend college immediately, don’t panic. Remember there are dozens of other higher education institutions that qualify as well. In addition, given the high cost of education many kids might prefer to work a few years or figure out a career path prior to attending school. If none of those apply try changing beneficiaries to another family member for use. As a last resort you could withdraw the money and pay federal taxes plus a 10% penalty on the gain.
If your child gets a scholarship or is accepted into a military service academy, there are additional guidelines you can follow. Assuming there are no other beneficiaries that need the money, you can withdraw funds up to the amount of the scholarship, avoid the 10% penalty, and just pay ordinary income taxes on the gain. There are many additional qualifying expenses to school besides tuition that remaining funds can be spent on or, as mentioned before, can be transferred to another beneficiary.
One lesser known but interesting fact relates to money ALREADY spent from a 529 plan that comes back. The PATH Act change added a special rule for a beneficiary of a 529 plan, usually a student, who receives a refund of tuition or other qualified education expenses. This can occur when a student drops a class mid-semester. If the beneficiary recontributes this to their 529 plans within 60 days, the refund is tax-free.
Where are the funds invested?
When you contribute to a 529 college savings account your investing options are limited by what the plan provides. Most plans give you three major options.
First is a conservative, savings account or CD like option. This often includes a guaranteed rate of return, although this can change at least annually if not more, and protection of your initial investment. The purpose is you can’t lose your contributions but don’t expect them to grow very much.
Second, is an age-based option, like a target date fund in a retirement plan. You pick some variation of the beneficiaries current age, the year they will attend school, or the number of years until school and the investments are selected and managed for you. These generally start out with a higher degree of risk the farther away the needed date is and gradually reduce that risk as the need for money approaches. This is tailored for a set it and forget it investor that wants help with their allocation and is willing to take on some risk to potentially earn a higher return.
Third, is the do it yourself model. Most 529 savings plans let you pick from a menu of individual mutual funds to create your own portfolio. This lets you select the amount going into stock or bond funds to decide your own risk level and even tilt your investments to areas of the market you think will do best. Building your own portfolio is useful when you want to maintain a set level of risk across a longer period of time, but it requires some due diligence to make sure you aren’t making any bets on the market you didn’t intend.
Any of these three can be good in the right circumstances. Don’t forget you have the right to change your mind along the way so starting with one option and switching down the line is always open to you.
Where do you open a 529 account?
529 Savings Plans can be opened directly through your states plan. Try Googling the name of your state and 529 plan and it will be one of the first options available. We typically prefer choosing this direct option, rather than through an advisor. Due to the limited options and time frame we feel there is less value that can be added by an advisor for investment management, and more in planning around how much to save, where it falls in the line of priorities, and how saving might impact taxes and aid eligibility.
When should I open a 529 account?
The answer is, as soon as you know you can afford to and want to make it a priority. The magical power of compounding works just as well for educational savings as it does for retirement savings. But it may not be advisable for someone to be putting money in a 529 plan when they aren’t saving for their own retirement. The saying “you can take out loans for college, but you can’t take out loans for retirement” holds true.
If you decide that you want to make college savings a priority at least be sure you are getting all of the matching funds available to you through employer retirement plans, have an adequate emergency fund, and have paid off any high interest debt you may have. If you don’t, your kids may be using that fancy new degree to help financially support you later in life. Nobody wants that!
How do I use a 529 Plan to pay for school?
This part is surprisingly simple. Each state’s 529 plan will have a clear distribution process. Usually it involves filling out a one- or two-page paper form, including your personal information, account information, and where the money should be sent. Some plans allow all of this to be done online, streamlining the process. Once submitted, the funds will be sent to you or the institution as directed on the distribution form.
Strangely enough, most don’t ask for a bill that the withdraw is being applied to. That responsibility is on you to document and store for your tax records, an honor system so to speak. It is a good idea to scan a copy of your expense (make sure it shows the year when it occurred) and save it with a copy of your distribution form and proof of payment to the institution. That helps keep all your ducks in a row should the IRS ever question your withdraw.
How much can I contribute to a 529 Plan?
Per the IRS Q & A on 529 Plans “Contributions to a 529 plan may not exceed the amount necessary to provide for the qualified education expenses of a beneficiary.” If that sounds ambiguous, it’s because it is. Really contributions are limited by the individual states. For example, Indiana has a plan contribution limit of $450,000 per beneficiary (no limit on the number of accounts, just total contributions).
Realistically, most families aren’t setting aside that much for education. If you did plan to make a large one-time contribution, there are two addition things to be aware of. First, 529 Plan contributions are considered to be a present interest gift, so they qualify for the annual federal gift tax exclusion of $15,000 for 2019. Any amount over that would be reported as a taxable gift on IRS form 709. That doesn’t mean you’ll pay the taxes because you could use part of your lifetime gift and estate tax exemption, which for 2019 is $11.4 million. Second, 529 plans receive special gift treatment allowing you to accelerate 5 years’ worth of gifts, or $75,000, in one calendar year but stretch it out over 5 tax years. This has been a useful planning option, especially for grandparents, provided the contributor doesn’t pass away during those five years and pull a proportionate amount of the gift back into their estate.
Common 529 Plan mistakes
Probably the two biggest challenges holding back wider adoption of 529 savings plans are lack of public awareness and misconceptions on the rules governing the plans. We hope this addresses both if these points effectively. The final goal is to get those who choose to participate a highlight of common mistakes that can be easily avoided.
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Not coordinating withdraws between parent and grandparent owned accounts and impacting student financial aid eligibility.
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Not taking out 529 plan distributions in the same tax year as the expense / bill is paid. Academic calendar years don’t count.
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Taking out distributions for non-qualified expenses or failing to keep documentation for expenses or payments made.
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Failing to anticipate educational tax credits. If you take out funds equaling 100% of your Qualified Educational expenses and then get an educational tax credit you may be taking out too much. You can’t cover the same qualified expense with a tax credit and a 529 plan withdraw. We’d recommend consulting with your tax advisor in advance (probably towards the end of the year) before taking out a final distribution for the year.
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Using 529 Plan funds for multiple kids without changing the beneficiary first.
We feel that 529 Plans have enormous potential for families looking to save for education. A small investment of your time to learn the rules and guidelines of 529 Savings Plans can pay off for not only for you, but for generations to come.