Unleash the Power of Education – Your Guide to 529 Plans
By Steven T. Merkel, CFP®, ChFC®
In an increasingly competitive and high-skilled job market, a college education is almost a necessity for young people who are jumpstarting their careers. Many employers are demanding a college-educated workforce, and the rise of technology and automation is steadily replacing millions of blue-collar jobs.
Higher education serves as the key that unlocks the door to success and upward mobility, but the opportunities afforded by a college degree come at a cost. College tuition and fees have skyrocketed over the past 40 years, increasing at nearly twice the rate as medical care (see figure 1).
Although public and private university expenses have risen at a comparable rate, the raw increase in costs for private institutions has been far more drastic (tuition and fees at private universities have gone up by more than $19,000 annually – see figure 2).
By steadily saving throughout your lifetime for this investment in your child and grandchildren, you can position them for future success in their career and help to alleviate the burden of student loan debt that could otherwise loom in their future.
Although there are many ways to save, 529 college savings plans are the most popular and effective vehicle for unleashing the power of education in your child or grandchild’s life.
Let’s take a closer look at how 529 plans work, the benefits and limitations of these accounts, and how the new tax law has impacted 529 plans.
Figure 1. The cost of college tuition and fees has increased by more than 1,000% during the 35-year period of 1968-2013 – far outpacing the rate of increase in healthcare, housing and other commodities.
Figure 2. For private universities in the U.S., the average cost of tuition and fees for the 2017-2018 academic year is $34,740. For public colleges and university, tuition and fees in 2017 dollars have more than tripled since 1987.
A 529 college savings plan is a tax-advantaged account that is specifically designed for future education expenses. When you establish a 529 plan, you designate a single beneficiary (typically a child or grandchild) who is the intended recipient of the savings.
The funds in this account may be utilized on behalf of the student at any college, university, trade school, or post-secondary institution that is recognized by the Department of Education (when in doubt, check with the school or institution regarding their eligibility).
As the custodian, you have control over the account. The beneficiary of the plan can be updated at any time, and the funds from one 529 plan may be rolled over to another 529 plan without penalty.
In terms of asset allocation, you have the ability to choose from a range of mutual fund and exchange-traded fund (ETF) portfolios based on your risk tolerance and savings target. Consult with your advisor for more details on which 529 investment strategy is best suited for your needs.
Every state in the U.S. sponsors some form of a 529 savings plan. More than 30 states provide you with tax benefits when you contribute funds to the account (typically in the form of claiming a deduction on your state income taxes).
Most states also exempt you from paying state taxes on the earnings of the 529 plan when you make withdrawals for qualified education expenses. The specifics of these plans can vary significantly state-by-state (see figure 3).
For all 529 plans, you do not pay any federal income taxes on earnings within your account as long as the withdrawals go towards qualified education expenses (see figure 4).
TIP: When making withdrawals from the 529 plan, you should maintain records of all qualified education expenses you have incurred. In the unlikely event that you are audited, the IRS may request documentation.
Figure 3. 529 plans are sponsored at the state level and are subject to different tax benefits. Some states offer a generous deduction on state income taxes, while others offer tax benefits upon withdrawal of funds for qualified education expenses.
Figure 4. If withdrawals from your 529 plan are spent on qualified higher education expenses, the earnings in the account are not subject to federal income tax (and are typically exempt from state income tax as well).
TIP: Under the new tax law, states have been granted the ability to classify tuition and fees for private K-12 schools – up to $10,000 – as qualified education expenses (check your home state’s 529 rules).
529 Plan Rules
As with most tax-advantaged investment accounts, 529 college savings plans are subject to legal restrictions:
Annual gift tax exclusion – Another advantage of 529 plans is the potential to apply contributions towards your gift tax exemption for the year. While leveraging this tax benefit is a great perk, there may be significant gift tax consequences if you contribute more than $15,000 per year individual limit ($30,000 for married couples) to a particular beneficiary.
We encourage you to be mindful of any other expenses you have applied to the gift tax exemption and to adjust your 529 contributions each year so that you fall below the $15,000 GST threshold ($30,000 for married couples).
Exception: Most 529 plans allow you to make a one-time, lump-sum contribution of up to $75,000 ($150,000 for married couples) to the account – as long as you do not gift any additional money to the account beneficiary over the course of the next five years. In essence, you can deposit five years’ worth of contributions at one time instead of contributing $15,000 annually.
Note: Additional contribution limits may apply to your account based on the regulations in place for your state’s plan.
Non-qualified withdrawals – Although you are technically allowed to take withdrawals from the 529 plan for expenses other than the qualified items listed in Figure 4, the earnings portion of these distributions are subject to 10% withdrawal penalty. In short, taking non-qualified withdrawals negate the tax benefits of the account.
Some examples of expenses that are classified as non-qualified include transportation costs, health insurance (even university-sponsored coverage) and student loan repayments.
Changes under the New Tax Law
The Tax Cuts and Jobs Act of 2017 had a direct impact on two key areas of consideration for 529 plans.
First, states have been granted the ability to classify tuition and fees for private and religious K-12 schools – up to $10,000 – as qualified education expenses. Most states have not yet codified this new rule into their respective 529 plans, but the notion of tax-efficient savings for primary education is certainly encouraging for those who have children and grandchildren enrolled in private schools.
Secondly, you now have the ability to roll over funds from a traditional 529 account to a 529 ABLE account. ABLE accounts are specifically designed to enhance quality of life for Americans with disabilities. This new law does not impact your ability to roll over funds from one 529 plan to another 529 plan.
In contrast, the following areas have not been impacted by the tax reform legislation:
- Coverdell Education Savings Accounts
- American Opportunity Tax Credit (AOTC)
- Student Loan Deductions
- Exemption of Tuition Fee Waivers from Taxable Income
Investing in the Next Generation
A 529 plan is an outstanding vehicle for preparing your children and grandchildren to pursue successful careers, as well as mitigating the massive debt burden they could accrue during their collegiate experience.
To further sweeten the pot, 529 plans also carry significant tax advantages for you – serving as an excellent tool for gifting funds to future generations.
Figure 5. The upsides to leveraging 529 plans as an education savings tool are wide-reaching.
Time and time again, our CAS team has witnessed the success of 529 plans in unleashing the power of education for future generations. Contact your advisor to discover more about how we can work together to provide a bright future for posterity while capitalizing on opportunities for tax efficiencies within your investment portfolio.
