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Should I Open a 529 Plan for my Child?

Should I Open a 529 Plan for my Child?

Client Question:  Should I open a 529 plan for my child?

Advisor Answer:  A 529 plan can be a great tool to save for education expenses; however, there are some drawbacks that are important to consider.

How does a 529 plan work?

From a tax perspective, 529 plans are very similar to Roth IRAs.  There is no federal income tax deduction for contributions made to 529 plans, but the assets within 529 plans grow in a tax-free manner.  Growing tax-free means that one does not pay taxes on any interest from bonds, dividends from stocks, or capital gains while assets are held in the account.  Also, no taxes are paid when funds are withdrawn from 529 plans for qualified eduction expenses.

For example, if $10,000 is initially invested in a 529 plan, and the account value increases to $30,000 after 20 years, no taxes will be paid when the funds in the account are withdrawn to pay for qualified education expenses.  This is in contrast to tax-deferred accounts like Traditional IRAs where 100% of the distributions would be taxed at ordinary income tax rates.

Is it too late to fund a 529 plan?

Ideally, it is most beneficial to start funding a 529 plan as soon as possible.  There should be more and more tax savings the longer funds are held in a 529 plan because one wouldn’t be paying taxes associated with interest, dividends, and capital gains that would result from investing in a normal taxable brokerage account.  Similar to saving for retirement, allowing invested assets to grow over a longer period of time should result in compound interest and exponential growth.

It can also make sense to fund a 529 plan even if your child is already attending college.  Although there is no federal income tax deduction for contributions made to 529 plans, there is a state income tax deduction in most states; however, a majority of states limit the deduction.  So, if you have an upcoming tuition payment to make, you can contribute the funds needed for the upcoming expense into a 529 plan and then immediately withdraw the funds.  In order to avoid potentially having to pay gift tax, each donor (e.g. parent or grandparent) should gift no more than $15,000 (2018 limit) to a beneficiary’s 529 plan.  A married couple could jointly gift up to $30,000 per beneficiary without running into any gift tax issues.

Two clients of mine who live in Colorado recently used this strategy and will end up saving thousands of dollars in taxes.  Colorado is one of the few states that does not limit the amount of money that can be deducted for 529 plan contributions.  Since Colorado has a 4.63% flat tax rate, feeding an upcoming $20,000 tuition payment through a 529 plan will save them $920 (4.63% of $20,000) in 2018.  Of course, over four years, this would add up to $3,680 in tax savings.  The savings multiply even more if one is paying for several children or family members to attend college!

What are the restrictions associated with 529 plans?

If funds are withdrawn from a 529 plan and used to pay for non-qualified expenses, there may be taxes and penalties.  Below are examples of qualified expenses:

  • Tuition and fees
  • Room and board
  • Textbooks and supplies
  • Technology

It is important to note that the taxes and penalties associated with non-qualified distributions are only applied to the earnings within the 529 plan, but not the contributions.  Unfortunately, assuming an account has earnings, there is no way to take out contributions without also withdrawing earnings because distributions are pro-rata.  So, if you had a 529 plan with $10,000 of contributions and $20,000 of gains, withdrawing $10,000 would result in a $3,300 distribution of contributions (one third of $10,000) and $6,700 of earnings (two thirds of $10,000).  Assuming this was a non-qualified distribution, the $6,700 would be subject to ordinary income tax rates and an additional 10% penalty.  If a child receives a scholarship for “X” amount of dollars, a 529 plan account owner can distribute “X” amount of dollars from the associated 529 plan without penalty; however, the earnings would still be subject to ordinary income tax rates.

How much should I invest in a 529 plan?

There are many people who inadvertently overfund 529 plans because the intended beneficiary attends a less expensive university, doesn’t attend college at all, or doesn’t finish a four-year program.  Although there is no way to know far in advance exactly how much money will be needed to cover a beneficiary’s education expenses, there are certain concepts that can help you plan.

Many clients I work with choose to fund only 50% of projected tuition and room and board for an in-state university.  This way, one is receiving the tax benefits of 529 plans, but is also decreasing the probability of overfunding a plan.  It is also important to account for the increasing price of tuition from year to year.  According to finaid.org, “During any 17-year period from 1958-2001 the average annual tuition inflation rate was between 6%-9%.”

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