Education Savings 101

Written By: Mac Frasier

Director of Planning, Advisory Services

Graduation season is upon us, and while many parents and grandparents of recent college grads may be celebrating, other parents now face the upcoming reality of paying for a college education. Since May is 529 Plan Awareness Month, I thought it may be a great time to write more about 529 plans and their role in financial planning.

What is a 529 Plan?

A logical place for us to start 529 Plan Awareness Month is by explaining what they are. 529 plans are tax-advantaged vehicles designed to promote education savings for a designated beneficiary.   Funds inside a 529 plan grow tax-free, and distributions are not taxed federally when used to pay for qualified education expenses. In most cases, qualified 529 plan distributions are also exempt from state income tax.

However, some states have unique rules regarding the taxation of 529 distributions (State tax treatment of qualified distributions). Until 2017 these funds could only be used for higher education (college and above) expenses; however the Tax Cuts and Jobs Act of 2017 expanded eligible expenses to include up to $10,000 annually in K-12 tuition.  Fun fact the 529 Plan is named after section 529 of the Internal Revenue Code.  Be sure to share this at the next cocktail party you attend.

Pros

  • Contributions grow tax-deferred and when used for a qualified expense the distributions are free from Federal Income Tax
  • The donor maintains control of the account unlike UGMA / UTMA’s which become the beneficiary’s asset between ages 18 and 21, depending on state law
  • Contributions are not limited by the income of the donor
  • Low maintenance – Many plans offer age-based models
  • In the case of a scholarship, non-qualified withdrawals up to the amount of the tax-free scholarship can be taken out penalty-free but you’ll have to pay income tax on the earnings (The truth about scholarships and 529 plans).

Cons

  • Non-qualified withdrawals are subject to income tax on the gains of the account plus a 10% federal income tax penalty
  • Investment options in a 529 plan may be limited by the plan sponsor
  • If claiming the American Opportunity Tax Credit* it is important pay for at least $4,000 of higher education expenses (textbooks and tuition) from non-529 plans

*Consult with your tax preparer

 

529 Plan – Strategies

Because 529 plans can be such a valuable tool for education savings, it is important to understand the different ways to fully utilize them.

  • Take advantage of potential state tax benefits – Over 30 states offer either a state income tax deduction or credit for contributions to a 529 plan. Visit Saving for College to learn more about your state’s 529 plan and potential tax benefits.
  • Changing an account beneficiary – For example, if one child receives a scholarship and does not use the funds, you can switch the plan beneficiary to another child
  • Get the Family (Grandparents) involved – A unique feature of 529 plans is the ability to front-load gifts.  This allows a donor to make 5-years’ worth of annual gifts in a single tax year ($75,000 based on current gift limits).   Given the uncertainty concerning future gift and estate tax law changes This can be a great way for grandparents to remove assets from their taxable estate while helping out a grandchild.   To learn more about this strategy visit: 10 Rules for Superfunding a 529 Plan
  • Make Saving a Habit (early & often) – Set up an automatic contribution to the 529 plan. Periodic contributions to 529 plans can be as low as $50.   A longer time frame allows the assets to potentially grow even more.

Frequently Asked Questions about 529’s

How do I choose which 529 plan to use?

Consider the follow when reviewing options

  • In-State Tax Benefits – Does your state offer a tax-benefit for utilizing the states plan?
  • Fees & Expenses – Review the accounts fees and management fees of underlying portfolios
  • Plan Performance – Review 1-, 3-, 5-, and 10-year performance if available

Does my child have to attend a school in the same state that my 529 plan is opened through?

No, your 529 does NOT limit you to schools within the state where it resides. You can use 529 money to pay for tuition and other qualified expenses at any eligible institution in the US, and even many international ones!

If I have more than one child, should I have more than one account?

It is best to open a separate account for each child – especially if they are less than 5 years apart in age. 529 plans are only permitted to have one beneficiary at a time.

Will investing in a 529 plan affect eligibility for financial aid?

Because 529 funds are considered to be an asset of the parent for the Expected Family Contribution (EFC), they have a relatively small impact on federal financial aid. If the 529 plan is owned by a grandparent or other person the impact on financial aid could be more significant.

Can I use the 529 to pay for my child’s private high school?

Yes, you may withdraw up to $10,000 per beneficiary per year to pay for certain K – 12 expenses

 

If you have questions about 529 Plans or education planning, please reach out to your client advisor.

Oakworth Capital Bank does not provide tax or legal advice.   All decisions regarding the tax and / or legal implications of these strategies should be discussed with your tax and / or legal advisors before being implemented.