Using 529 Plans for College Funding – Part 1

Key Takeaways

529 plans are tax-advantaged education savings accounts operated by state or educational institutions.

  • In most types of 529 plans, earnings are tax-deferred while in the account, and tax free when withdrawn for qualified education expenses.
  • Some states, including Pennsylvania, allow your contributions to be deductible at the state level.
  • As with so many other important investments you make, it’s about more than just returns–you have to look carefully at fees and tax implications.

Despite the fact that college costs are rising substantially faster than the rate of inflation, study after study confirms that in most cases, a college education is one of the best investments you can make in your child’s future. But it’s not cheap.

Saving for college sooner rather than later is more important than ever.  Take a look at this chart to see how high college tuition costs are right now and where they are projected to be in the future:

chart1

 

“Based on average tuition and fees for as reported by SavingforCollege.com and assumed to increase 5 percent annually.

Given these figures, it’s important to take advantage of every tax savings opportunity you have.  Here we’ll discuss 529 plans–a college savings vehicle that we are big fans of.

Introduction

A 529 Plan is an education savings plan that’s operated by a state or educational institution in order to help families and relatives set aside funds for future college costs. The plans are named after Section 529 of the Internal Revenue Code which created such savings plans in 1996.

Types

There are two types of 529 plans. The one we will focus on in this post is the contributory 529, which enables a person to make contributions, invest them, then use the money tax free for college expenses.  These plans allow a beneficiary (i.e., the future student) to use the funds at any college, for any course of study regardless of a school’s location.  The funds must be used for educational purposes only—they can’t be used for public or private K-12—but can be rolled over to another sibling or immediate relative if the primary beneficiary doesn’t use the funds.

The other type of 529, called a prepaid 529 plan, allows you to pre-pay all or part of the cost of an in-state college, thus avoiding the impact of burgeoning higher education costs, which as shown in the chart above, are rising substantially faster than the rate of inflation.  However, prepaid 529 plans can greatly limit the schools the beneficiary attends, because again, they can only be used for in-state colleges, so we don’t normally recommend prepaid 529’s.

Let’s take a look at some of the advantages and disadvantages of contributory 529 plans.

Advantages

  • Federal tax – Earnings are tax-deferred while in the account, and tax free when withdrawn if used for qualified education expenses.
  • State tax – In certain states, contributions may be deductible at the state level.  For instance, Pennsylvania residents receive a deduction of up to $14,000 per year for contributions to any 529 plan in the country.
  • Gift tax – Contributions qualify for the $14,000 annual gift tax exclusion ($28,000 total for married couples).  Additionally, there are ways of front loading the account with as much as $70,000 ($140,000 total for married couples) of contributions into one year while still facing no gift tax consequences.
  • Control – Parents or other account holders have full control over investment choices and distributions.  Compare this to custodial accounts such as UGMA/UTMA’s where parents lose control when the child hits age of majority (typically 18).
  • Change of Beneficiary – Beneficiaries can be changed to any other member of the original beneficiary’s family.

Disadvantages

  • Fees – Most state plans charge administrative fees as well as fees within the investments.  When shopping around for plans, make sure you take fees into account.
  • Inflexible – If money is withdrawn from a plan for anything other than qualified college, there may be taxes and penalties to pay.
  • Limited investments – Much like company 401(k) plans, 529 plans have limited investment options.  Picking the plan with the investment options you like is a critical decision.
  • Financial aid – When 529’s are started by anyone but the parent or beneficiary, it can greatly limit the amount of financial aid the beneficiary may be eligible for.  Click here for a previous blog post where we discuss ways around this.

In part 2 later this week, we’ll compare a few actual plans.  If you have questions regarding 529’s or want to start investing in them, please feel free to email me or call the office at : (800) 588-1732.  We are happy to help.

About Patrick Runyen

As a Wealth Manager at Independence Advisors, Patrick Runyen, CPA/PFS, CFP® works closely with clients to implement wealth management solutions. He leverages his technical financial planning and consulting experience to assist clients with investment counseling, retirement planning, estate planning, wealth enhancement, asset protection, tax planning, and other personally significant financial decisions. CLICK HERE TO ASK PAT.

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