A 529 College Savings plan is a tax-advantaged education savings plan that is set up by your state to allow you to put aside funds for future higher education expenses. Let's take a look at a few things to consider in order to maximize your results when funding these plans.
- Invest in an Age-based Portfolio
- These types of funds offer a diversified portfolio within a single fund that adjusts its underlying asset mix over time. As the child gets closer to college age (usually age 18) the fund will incrementally decrease its exposure to stocks and increase the percentage toward bonds. Why is this important? They protect against what is technically identified as an "asset-liability mismatch". Simply stated, this is when one is trying to support short-term spending (spending for the next 3 to 5 years) with long-term investments. Equity or stock investments require a long-term time horizon (generally 5-10 years) in case of market correction. Some market recoveries take only a couple of years, others have dragged on for nearly a decade. If you need to sell these investments before a full market recovery you will create a permanent loss which could be very detrimental to the value of your account and the ability to fund the student’s college costs as planned.
- Front Loading to Maximize Tax-Free Growth
- Since these plans are allowed to grow tax-free (if used for qualified education expenses), it is important to start funding these plans early in the child's life to receive the most tax benefit. As discussed above, a 529 plan will need to be invested according to the timeframe that the funds will be used. For example, the stock exposure should decrease and holdings in conservative bond investments should increase the closer the student is to college age. As we know, bonds and fixed income investments historically have less risk and in turn, less reward or growth. Keeping this in mind, your ability to maximize your tax-free growth in the later years of the plan is minimal. So, again, consider funding these plans at an early age (when maintaining a more aggressive portfolio is generally suitable) to maximize the tax-free growth potential.
- Front-loading funds in 529 plans also allow for the impacts of compounding returns to work their magic!
- Avoiding Federal Gift Tax and Gift Tax Reporting
- 529 plan contributions are considered to be completed gifts to the beneficiary and may be subject to federal gift tax and gift tax reporting. There is an annual gift tax exclusion which allows for a $15,000 gift (as of 2021) per donor, per recipient to be excluded from gift tax. For a married couple filing jointly, the limit is $30,000 per recipient (known as gift splitting). There is also an opportunity to do what is known as "super funding". This is a special ruling by the IRS that allows you to do a one-time lump 529 plan contribution equal to five years of the annual gift limit ($75,000 for someone filing “single” and $150,000 for a married couple filing “jointly”) without triggering a reporting requirement against your lifetime gift tax exclusion. This can be used in concert with the front loading discussed above.
- Payments of college tuition directly to the school or qualified institution do not count against the lifetime gift tax exclusion but, be aware that such a payment may impact the student's eligibility for need-based financial aid.
- It is important to note, if funds in a 529 savings plan are withdrawn and not used for qualified higher education expenses, the gains will be subject to income tax and a 10% penalty. Therefore, you will not want to over-fund these plans.
- There are some exceptions to the 10% penalty on non-qualified distributions; for example, the beneficiary receives a tax-free scholarship, receives benefits for attending a U.S Military Academy, receives educational assistance through a qualifying employer program, or becomes deceased or disabled.
- The owner of a 529 plan (usually a parent or grandparent) can also change the beneficiary to another qualifying family member. Generally, one's child or grandchild will meet the criteria of a qualifying family member. That means if you have more than one child and that child does not use the funds in his or her 529, the funds can be switched to a sibling and avoid any penalties or taxes if used for a qualifying education expense. You should check with your plan provider to determine who a qualifying family member would be.
- Funds in a 529 plan can also be used to pay for graduate school or post-secondary vocational or technical programs as well as private K-12 educational expenses (although there is a cap on private schooling costs).
- State Tax Deduction or Credit
- Depending on where you live, some states offer a state tax deduction or tax credit on a certain amount of your 529 plan contributions. Oftentimes, this deduction or credit is per beneficiary. Check with your 529 plan or state to see if you are eligible and consult with your tax-preparer to take advantage of the benefit if applicable.
There are many different options for college savings, and each has its own implications for taxes, gift & estate planning, financial aid and a host of other issues. The best option for you will depend on your specific financial situation but, if you decide to pursue the 529 plan, you will want to keep these important issues in mind.
About the Author:
Breanna Stein, CFP® is an Associate Financial Advisor at Fullen Financial Group. She graduated Cum Laude from The Ohio State University with a Bachelor of Science in Consumer and Family Financial Services and a minor in Business Administration from the Fisher College of Business. During her time at Ohio State, she served as the president of The Student Financial Planning Association. Prior to joining Fullen Financial, Breanna worked for Ameriprise Financial, gaining meaningful industry experience. Breanna is originally from a small town in Northwest Ohio and now residing in the Columbus area. She is a member of the Financial Planning Association of Central Ohio as well as their NextGen chapter.
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