For many families, paying for college is an enormous responsibility and the costs are daunting. Tuition has risen at an average of 5% per year over the past decade, significantly outpacing the general rate of inflation. Total outlays for a four-year private college education can exceed $200,000. Using a Qualified Tuition Program (529 account) is an efficient way to save money for future school-related expenses.
The benefits of 529 accounts include:
Below we discuss a number of the key features and important issues to consider for your 529 investment.
One Goal, Two Programs. Plans that fall under Section 529 of the Internal Revenue Code are called Qualified Tuition Programs and are designed to encourage families to save for future education costs. A key benefit comes from the tax-free earnings and withdrawal of earnings that build up in the plan. There are two types of programs: Prepaid Tuition Plans and Education Savings Plans.
Prepaid Tuition Plans allow the plan holder to pay for the beneficiary’s tuition and fees at designated institutions in advance. Parents purchase credits that will cover their child’s future tuition, typically at an in-state public university, at current rates. A limited number of states offer these plans.
Education Savings Plans are state-sponsored, tax-advantaged investment vehicles, similar to IRAs. Education Savings Plans typically provide greater flexibility than Prepaid Tuition Plans because they offer multiple investment options and account assets can be utilized for a broader range of expenses. The rest of this article focuses on this type of program.
Constituents. A 529 plan can be set up by anyone, including non-relatives, for a designated beneficiary. Whoever purchases the 529 plan is the owner and controls the funds until they are withdrawn. Anyone can make a contribution into a 529 account, and the designated beneficiary is the future student for whom the plan is intended to help.
Plans are sponsored by states or state-run agencies. Each state selects a manager to provide investment options for its plan. You are free to set up your 529 account through your state-sponsored plan or purchase a plan from another state. You may forego a deduction on state income tax by choosing an out-of-state plan. However, other plans may offer more attractive investment options and / or lower fees.
Qualified Expenses. To take full advantage of the tax benefits of a 529 plan, withdrawals must be used to pay for qualified education expenses. These include tuition, required fees, books, supplies, certain required equipment and the cost of room and board. Under the new Tax Cuts and Jobs Act, the definition of qualified education expenses was expanded. You can now use a 529 to cover up to $10,000 in annual costs for tuition at elementary or secondary schools.
Choices. Setting up a 529 plan is both a savings and an investment decision. Once you put money into a plan, it must be used to pay for qualified education expenses or you will forfeit the tax benefits. The full tax benefits of purchasing an in-state plan generally apply only if you or your beneficiary live or pay state income taxes in the 529 plan sponsor’s state.
College savings plans are generally managed by mutual fund companies, and your contributions are invested in underlying investment options. Most plans offer the following types of investment options: static investment portfolios; age-based or years-to-enrollment options; and individual fund investment options. Your investment will fluctuate in value so there is no guarantee that the amount contributed to the plan will equal the amount necessary for future education expenses.
Costs. Before purchasing a plan, you should review the plan program disclosures – also sometimes called the ‘program description’ – to understand the fees and expenses that you’ll pay. Costs are typically calculated as a percentage of your account balance and vary from plan to plan. Expenses may include: program management fees, state administration fees, annual maintenance fees, enrollment fees, termination fees, underlying mutual fund expenses and possibly sales charges and service fees.
Tax Considerations. Using a 529 provides a variety of state and federal tax benefits. Most states offer some form of state income tax deduction or credit for contributions made to a 529 plan that they sponsor. Earnings are not subject to federal tax and generally not subject to state tax when used for qualified education expenses. Moreover, when the money is used for qualified expenses, the distributions from the plan are not subject to federal or state income taxes.
The owner is able to change the beneficiary to another member of the family without tax consequences. Also, any funds distributed from a 529 plan are not taxable if rolled over to another plan for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family.
Penalties for Non-Qualified Expenses. If you are the owner of the plan, you don’t lose the money you put in if you don’t use it for qualified education expenses. However, you will lose tax benefits. Non-qualified withdrawals are taxed on a pro-rata basis, which means a portion of your withdrawal will be treated as a return of your contribution and a portion will be treated as earnings.
You will owe federal and state income taxes on the earnings portion of your withdrawals for non-qualified expenses, and you will likely have to reimburse the state if you claimed a deduction or credit for your original contribution. You will also be assessed a 10% penalty on earnings used for non-qualified expenses.
Contribution Limits. Each state limits the total amount of contributions made on behalf of a particular beneficiary. Contributions generally cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary, so the limits are typically quite high. There also may be federal gift tax consequences if your contributions to a particular beneficiary exceeds $14,000 during the year.
Next Steps. You derive the most value out of tax-free investment earnings and the compounding of those earnings when you have a long time horizon to invest. Establish a 529 account as early as possible so you can maximize this benefit. Remember that not all 529 plans are created equal. Some have high fees or poor investment choices, which can hamper your savings progress. Be sure to compare the various features of different plans. Focus on investment options and fees. FINRA and your state’s educational financing agency are helpful resources when considering 529 plan options. And, of course, your adviser at Laurentide can offer guidance when choosing a plan and investing your college savings dollars.
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Rob Kania is Principal and Co-founder at Laurentide Advisory