College Savings Plans have a number of nuances such as whether or not you receive a tax deduction, which schools are eligible, how financial aid will be impacted, which expenses are eligible, etc… In today’s blog post you will learn about these and other topics so that you can make informed college planning decisions.
For today’s purposes, I will be referring to 529 Plans when discussing college savings plans. Previously, there were Coverdell Savings Accounts, which were for intended for K-12 and college savings; however, they have essentially been overtaken by 529 Plans. With that in mind, I’ll start off with a description of what a 529 Plan is.
WHAT ARE 529 COLLEGE SAVINGS PLANS?
You may be thinking that “529” is an awfully weird name for a college savings plan. I would agree. However, the reason for the name is that it represents Section 529 of the Internal Revenue Code. Not as exciting as you were hoping, right?
A 529 Plan is essentially an education savings vehicle. So, people who want to plan ahead and save for their children’s future education would likely use a 529 Plan. Typically your money would be invested in various stock and bond mutual funds.
When you invest in a 529 plan, your contribution may be tax deductible, meaning that you wouldn’t pay any tax on that contribution. Each state has its own 529 plan, so you have to check to see what tax provisions your state allows. For example, in my home state of Missouri, we get a state tax deduction of up to $16,000 when we contribute to a 529 Plan. This would save Missouri taxpayers up to $1,000 in state taxes every year.
As mentioned above, your contribution into a 529 Plan is usually invested in stock and bond mutual funds. 529 Plans allow this money to grow without you paying any tax along the way or any tax when you withdraw the money so long as it’s used for qualified education expenses (i.e. tuition, fees, room, board, books, computers, internet, and supplies).
WHICH SCHOOLS ARE ELIGIBLE?
While it’s true that you have to use the 529 money on qualified education expenses in order to receive a tax free benefit, you must also use the money at an eligible financial institution in order to receive the tax free benefit.
An eligible institution is any college, university, vocational school, or other post-secondary school (i.e. beyond high school) that participates in the FAFSA (Free Application for Federal Student Aid) program.
Also, as part of the 2017 Tax Cuts and Jobs Act, 529 money can now be used for K-12 tuition. Up to $10,000 per year per beneficiary can be used in a tax free manner.
If 529 funds are not used for qualified education expenses or at a qualified institution, then any earnings (i.e. growth) on your money is subject to income tax and a 10% penalty.
TYPES OF 529 PLANS
Essentially there are 4 types of 529 Plans: Advisor Sold, Direct Sold, Pre-Paid, and ABLE Plans.
Advisor Sold vs Direct Sold
Let’s first tackle Advisor Sold and Direct Sold Plans. Advisor Sold Plans are those that you obtain directly through a financial advisor. Direct Sold Plans are those that you buy directly through the 529 Plan.
Advisor Sold Plans are usually much more expensive and have build in commissions, so we stay away from them. As a result, we use the Direct Sold Plans for our clients.
Pre-Paid 529 Plans
With this type of 529 plan, you pay tuition at today’s rates instead of at anticipated higher rates when your child goes to school in the future.
There are many different nuances to pre-paid 529 plans and every state’s plan is different (if they even offer one in the first place).
Some of the nuances to look into are: (1) whether or not anything is covered above and beyond tuition and fees, (2) whether you have to be a resident of the state where the school is located, (3) whether or not the funds can be transferred to a new school if you change your mind about where you want to go to school, (4) what penalties are involved if you end up going to a different school (especially one in a different state) than originally planned.
As a result of these things, I encourage you to find out what your state pre-paid 529 plan allows and doesn’t allow.
529 ABLE Plans
529 ABLE Plans are for special needs children and allow you to use your funds to pay for qualifying disability expenses.
These plans will not affect any Medicaid benefits being received, but could affect SSI benefits if 529 balance exceeds $100,000.
Not all states have ABLE plans.
Each state will have its own investment choices, so you’ll have to investigate whether or not your home state’s 529 plan has choices you are comfortable with. And if you decide to go with a different state’s 529 plan, you may not be eligible for the state tax deduction that I discussed earlier. Check to see what your state’s 529 plan allows.
Other investment options that a person has are whether or not to invest in an Age-Based investment portfolio or a Static investment portfolio.
An Age-Based Portfolio is one where the risk automatically lowers as the beneficiary (i.e. future student) gets closer to starting school.
A Static Portfolio is one where you invest in a portfolio with a particular risk profile. For example, you may choose to invest in a risky investment portfolio today, but if you ever wish to reduce the risk of the investment portfolio, you must do so manually. For this reason alone, I would say that Age-Based portfolios are more popular.
HOW IS FINANCIAL AID IMPACTED BY HAVE A 529 PLAN?
The Owner of the 529 Plan Matters
Usually a parent owns the account for the benefit of their child(ren), instead of the child(ren) owning the account. This is advantageous as only 5.64% of parent-owned accounts count as an asset for financial aid, whereas 20% of child-owned accounts do. Any withdrawals made from a parent-owned 529 account, if used for qualifying higher education expenses are not counted as income for financial aid purposes.
Grandparent-Owned 529 Plan
It’s common for grandparents to want to contribute to their grandchildren’s 529 accounts. In some cases, they give the money to the parents and then the parents deposit the money into the parent-owned 529 plan. In other cases, grandparents decided to set up their own 529 account for the benefit of their grandchildren. One major thing to keep in mind with grandparent-owned 529 plans is that 50% of a distribution could count as income for financial aid purposes.
As you can see there are many nuances to 529 College Savings Plans. Hopefully this blog post has helped you to have a better understanding of the tax treatment, types of 529 plans, expense eligibility, institution eligibility, investment options, and financial aid impact.
If you have any thoughts, comments, or questions please share them below.
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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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