Since the late 1980s, 529 plans have been a valuable tool to tax-efficiently fund a college education. However, it’s important to note that these plans are no longer limited to higher education costs: thanks to the Tax Cuts and Jobs Act of 2017, 529 plans can now be used to finance the cost of K–12 private school costs as well.
As more families turn to private schools for their child’s education, now is a great opportunity to review and discuss some of the most frequently asked questions we get about 529 plans. If you are already familiar with the basics of 529 plans, consider jumping ahead to the section of this article that is most relevant to you and your family.
What is a 529 Plan?
529 plans are tax-advantaged savings plans that are designed to cover education costs. There are two types of 529 plans: prepaid tuition plans and education savings plans.
Prepaid Tuition Plans
As the name implies, prepaid tuition plans allow parents, grandparents, and others to purchase course credits at participating colleges and universities (usually public and in-state) at current prices to be used later by the beneficiary. Prepaid tuition plans can be a very appealing option, especially for very young children: on average, tuition costs increase by about 8% every year, so purchasing course credits today can help save a significant amount in future tuition costs.
However, there are some drawbacks to these plans. For starters, prepaid tuition plans are becoming increasingly rare in the United States: in the past, 22 states offered these plans, but as of 2020, that number has dropped to nine. Furthermore, prepaid tuition plans can only be used to pay for tuition costs, which means room and board or other fees still need to be paid for when the child is ready to attend college. Finally, prepaid tuition plans only apply to colleges and universities — elementary or secondary school tuition costs cannot be covered by these plans.
Education Savings Plans
The other, more popular version of the 529 plan is the education savings plan, which allows savers to set aside money for any future qualified higher education expenses: tuition, fees, and room and board. What’s more, education savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at elementary and secondary schools. And unlike prepaid tuition plans, every state offers some form of education savings plan.
Education savings plans do have some restrictions that savers should be prepared for, especially concerning room and board. Approved costs for these items are capped based on each school’s average cost of room and board, so if the student wants to live in an off-campus apartment, the funds in an education savings plan may not be able to cover the total cost if off-campus housing is significantly more expensive than on-campus equivalents. However, the funds can still be used to partially cover the cost of off-campus living.
What Are the Tax Benefits of 529 Plans?
Because each state determines the tax benefits, fees, plan offerings, and administration requirements for 529 plans, the state tax benefits associated with these plans will vary. Most states allow savers to deduct contributions from their state income tax; for example, an individual saver living in Illinois can deduct up to $10,000 per year in 529 contributions, while married couples filing jointly can deduct up to $20,000 per year.
There are no federal tax deductions for contributions to a 529 plan. However, earnings within the plan are not subject to federal tax, either, and future distributions from a 529 plan are not subject to state or federal tax as long as they are used for qualifying educational expenses.
How Many 529 Accounts Can I Have?
In theory, there is no limit to the number of 529 accounts an individual can have. In practice, however, the more accounts there are, the more difficult it is to keep track of them. In addition, the owners’ relationship to the beneficiary of a 529 account can also affect the beneficiary’s FAFSA and student aid award amounts. It is not uncommon for direct family members (e.g., grandparents, aunts/uncles, etc.) to open their own 529 account in the beneficiary’s name, but they are not required to do so. In fact, it is often easier for them to contribute to an existing 529 account, rather than opening a new one.
Who Can Be Named A Beneficiary?
Anyone can be named a beneficiary of a 529 account, but switching beneficiaries can be tricky if the new beneficiary is not a close relative. In fact, switching the beneficiary to someone who is not a family member will likely trigger a 10% penalty on the earnings in the account and may even be considered a gift by the IRS. For these reasons, we recommend getting a personalized consultation before switching beneficiaries if the new individual is outside of the family.
What’s The Right Asset Allocation Strategy For A 529 Plan?
Your asset allocation strategy will depend primarily on your time horizon. If the account is established for a newborn child and the goal is to pay for college, you will have roughly 18 years until the funds are needed; accordingly, you should consider taking a more aggressive asset allocation with the account. For many people, this is a 100% equity allocation.
Once college approaches or your funding goals have been achieved, preservation of the account value becomes paramount. To achieve this shift, many savers will de-risk the portfolio after their funding goals are achieved, either by switching the account to cash and/or substantially reducing the equity portion.
If, on the other hand, paying for a child’s primary or secondary education is the goal, your investment time horizon will be much shorter. In that case, you may want to consider a more balanced allocation that gives you moderate growth potential while limiting near-term downside risk. Our team can help you define a prudent asset allocation based on your saving goals and time horizon.
How Has Recent Legislation Impacted 529 Plans?
As noted above, the 2017 Tax Cuts & Jobs Act expanded 529 plan eligibility to include K–12 education costs in addition to college costs. The SECURE Act also introduced several new changes to 529 plans, the most significant being that savers can now use $10,000 per individual to pay down student loans.
What If I Save More Than I Need?
If you have more money saved than you need, you have a few options for the leftover funds.
Take a non-qualified distribution of the excess funds.
These withdrawals are taxed as ordinary income, and there is a 10% penalty for distributions that do not go towards qualified education expenses, so this option may not be the most attractive to you; however, if the funds will otherwise go unused, it may be your best course of action.
Switch the beneficiary.
If there is another immediate family member who could use the funds, you can change beneficiaries on the account and use the excess funds to boost the education savings for another beneficiary. If the new beneficiary is not a close relative, however, changing the beneficiary can be a complicated process that may incur tax penalties.
Lastly, you can also leave the account as-is for the student to use at their discretion. Any earnings will continue to accrue tax-free, and if the student has a child of their own, they can change the beneficiary and use the account for their child’s education. Alternatively, if the current beneficiary decides to pursue a graduate or postgraduate degree, the funds will still be available for them to use.
We hope this article has given you some insights into the variety of planning opportunities that 529 plans can offer. If you would like help establishing or managing a 529 plan, we invite you to connect with our team.
ABOUT THE AUTHOR: JEFFREY FOSSELMAN, CPA, CFP®, JD
As Senior Wealth Advisor for Relative Value Partners, Jeff Fosselman provides comprehensive advisory services in estate planning, income tax planning, cash flows, asset allocation and other financial planning areas. With more than a decade of experience in the industry, Jeff is instrumental in delivering financial planning strategies and counsel to high-net-worth individuals.
Previously, Jeff was a Tax and Financial Planning Manager with Charles Wm. Foster & Associates where he provided comprehensive financial planning services, income tax compliance and planning counsel to high-net-worth individuals and families. Jeff is also an attorney and has provided basic legal services in the areas of business consultation, formation of legal entities and drafting of estate planning documents.
Graduating with a Bachelor of Science from the University of Illinois in 2000, Jeff continued his studies and earned his Juris Doctor from the University of Illinois College of Law in 2003, and a Master of Science in Taxation from DePaul University’s Charles H. Kellstadt Graduate School of Business in 2010. He is also a member of the American Institute of CPAs – Personal Financial Planning Section and holds a CPA license with a Personal Financial Specialist designation. Further, Jeff is a CERTIFIED FINANCIAL PLANNER™.
Information contained in this article is obtained from a variety of sources which are believed though not guaranteed to be accurate. Past performance does not indicate future performance. This article does not represent a specific investment recommendation.
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