Section 529 Plan: An Effective Strategy to Save for Education Costs
Key Points:
Education costs, particularly college tuition, have consistently outpaced the rate of inflation over the last three decades.
Planning for college education costs can help to have a positive impact on your retirement goals, while providing possible estate and tax benefits that utilize growth and income tax deferral.
Various strategies to fund college education costs include the use of custodial accounts, education trusts, 401(k) accounts, and IRA accounts. However, the most common strategy used for education funding is the Section 529 Plan.
Education costs, particularly college tuition, have consistently outpaced the rate of inflation. According to the College Board, the average cost of private college tuition has doubled over the past thirty years, while the average cost of public college tuition has more than tripled. The average annual cost of a four-year education, including room and board, ranges from $38,330 to $49,870, depending on choice of public or private schooling.¹ For an average couple who have two children to support through four-year degrees, they could be looking at a total cost of almost $400,000, which can have a significant impact on a savings plan whether for retirement or otherwise.
Proper planning for these education costs can help alleviate the impact on your retirement goals, while providing possible estate and tax planning benefits that utilize growth and deferral techniques. Some common strategies to save and grow assets to fund education costs include the use of custodial accounts, education trusts, 401(k) accounts, and IRA accounts. However, the strategy used most often by families to maximize growth potential is to save and invest money in a Section 529 College Savings Plan (529 Plan). (See Figure 1.)
A 529 Plan is an investment account created by a Donor or Grantor, which names a beneficiary on the account, such as a child or grandchild. Funds contributed to the account are allowed to grow tax-free, as long as the dollars are used for qualified education expenses when withdrawn.
A 529 Plan is an investment account created by a Donor or Grantor, which names a beneficiary on the account, such as a child or grandchild. Funds contributed to the account are allowed to grow tax-free, as long as the dollars are used for qualified education expenses when withdrawn.
Benefits and features of 529 Plans
Contributions
Contributions to a 529 Plan are very flexible. In most cases, a 529 Plan can be created with a very minimal initial contribution. On the other hand, a 529 Plan can also be funded with larger amounts to allow for the most growth possible and provide estate planning benefits.
In 2020, individuals may contribute up to $75,000 ($150,000 with spousal consent) in a single year to a 529 Plan account without incurring gift tax. With the $15,000 annual exclusion limitation, this would count as a series of five equal annual gifts. Contributions into 529 plans enable individuals to immediately remove these funds from their estate while still having full control over the assets. Most state savings plans allow individuals to accumulate significant account balances over time, often in excess of $250,000. There are also no contribution restrictions based on income levels of the donor.
Tax benefits
When assets are withdrawn to pay for qualified education expenses, there are no federal or state income taxes assessed on the earnings. Qualified education expenses include not only tuition and fees, but also books, supplies, and certain room and board costs.
Each state maintains its own 529 Plan. Some states provide additional state income tax deductions for residents who contribute to their state’s 529 Plan. For example, Illinois provides a deduction of up to $20,000 per year on contributions to an Illinois 529 Plan for a married couple filing a joint return. In addition, some states allow state income tax deductions even if you contribute to any state savings plan.
Individuals can contribute to one or any number of any state’s 529 Plans regardless of residency. This gives them flexibility to contribute funds to multiple plans, if desired, while adding a diversification element to their education funding program.
Flexibility
Most state plans allow 529 Plan balances to be used at any qualified institution. These typically include any qualified public or private institution, two-year community college, or vocational technical school in the United States.
In addition, under recent legislation, starting in 2018, funds from 529 Plans can also be used to pay for elementary and high school tuition expenses up to $10,000 per year while avoiding federal taxes. The state tax treatment of this new rule varies based on individual state laws.
The 529 plan also provides flexibility with the beneficiaries on an account. College funding plans sometimes change for families. When this occurs, the named beneficiary on an account balance can be transferred to other beneficiaries with no gift tax implications, penalties, or federal income tax implications, as long as it is done only once per year.
Regardless of the 529 plan you choose, you are also allowed to rollover amounts tax-free from one state plan to another as often as once every 12 months, without the need to change beneficiaries. This can also include a transfer between a 529 prepaid tuition program and a 529 savings plan run by the same state.
Professionally Managed Investment Options
Assets in 529 Plans typically offer professionally managed investment options according to the portfolio allocation that you select or that automatically applies based on the age of the beneficiary. Age-based portfolios are one option that offers a combination of stock, bond, and money market funds, with the percentage of holdings in these investments varying based on the age of the beneficiary. The younger the child, the heavier the weighting in stock funds. As the child ages, the allocations automatically shift towards more conservative bond and money market funds.
529 Plan Concerns
Withdrawals may be made for non-qualified education costs. However, earnings on such withdrawals will be taxed as ordinary income at the account owner’s tax rate, and an additional 10% federal tax penalty (on the earnings) will be incurred. There will be no penalties assessed in cases of death, disability, or scholarship.
A common concern about 529 plans is that they may negatively impact the ability to receive financial aid. The good news is that 529 plan balances have very little impact on the financial aid formula, as long as the beneficiary of the account is not also the owner.
Conclusion
The main benefits of using a 529 Plan include the reduction of income and estate taxes, and the ability to invest and grow assets tax efficiently over a long period. Regardless of the funding strategy one chooses, planning for education costs in advance can provide many benefits, and help one avoid any negative impact on retirement goals. For many, the use of a 529 Plan for education savings helps them meet this goal. Learn more with Capstone Financial Advisors.
Sources:
¹ https://research.collegeboard.org/trends/college-pricing/figures-tables/average-published-charges-2018-19-and-2019-20
SHARE