College Savings Plans: The Magic Number is 529
For a standout option for college savings, look no further than 529 plans. 529 plans are investment accounts with tax-deferred earnings and tax-free withdrawals, as long as they are used for qualified education expenses. 529 plans, also known as “qualified tuition plans,” are sponsored by states, available directly from plans or through advisors, and take their name from Section 529 of the Internal Revenue Code.
There is a second, little-known category of 529 plans called “prepaid tuition plans,” somewhat antiquated plans where you can lock in a tuition rate through the purchase of credits. However, these plans have many limitations and states are beginning to drop them. The first category of 529 plans discussed here have far greater visibility and popularity.
Along with tuition, 529 plans can be used to pay for qualified education expenses including room and board, fees, books, computers and related equipment, and supplies. However, earnings on withdrawals used for non-qualified expenses are subject to federal and state income taxes and a 10% federal penalty tax. 529 plans offer flexibility with choice of schools and can be used at a variety of institutions, including colleges, universities, trade or technical schools, and some foreign schools.
In addition to the benefit of tax-deferred earnings and tax-free withdrawals, some states offer tax deductions or credits for 529 plan contributions. In many cases, if the maximum deduction is met in one year, the deduction can roll over into subsequent years. Almost all states mirror federal law and offer state tax exemptions on withdrawals.
You don’t have to save in your state’s plan. The key is to first look at your state for tax deductions or credits, and if there is one, it usually makes the most sense to claim it. But if you live in a state with no income tax or you don’t have any tax deductions or credits available, by all means shop around with other states’ plans and compare and contrast their performance.
529 plans are very accessible, with investment minimums as low as $10 and high contribution limits. Individuals can apply the $14,000 annual gift tax exclusion to their contribution for one year ($28,000 for couples), or make up to 5 years worth of contributions at once by contributing $70,000, without triggering the gift tax ($140,000 for couples). For high-net-worth folks, this gifting strategy can be used to reduce the size of their taxable estate. Lifetime maximum account values are between $300,000-$400,000 per beneficiary, depending on the state, and a beneficiary can have multiple accounts as long as the total money in all accounts does not exceed the state limit on contributions. Anyone can contribute to 529 plans – grandparents, parents, aunts, uncles, friends, and so on.
The 529 account owner retains full control of the assets throughout the lifetime of the account, including the right to take the money back (although this would be a non-qualified withdrawal and subject to federal and state income taxes and the 10% federal penalty tax). If the original beneficiary gets a full scholarship, ends up with an unused balance, or doesn’t go to college, the account owner can change beneficiaries or transfer assets to another family member, as many times as needed. The IRS’s definition of family member is generous, including step-siblings and first cousins, for example. Account owners can also use the plan for their own educational needs.
To minimize impact on financial aid, it’s generally best for 529 account owners to be the custodial parent(s). Assets in a 529 plan held by a custodial parent count against need-based aid up to a maximum of 5.6%, whereas withdrawals from a 529 plan held by grandparents or non-custodial parents are considered untaxed income to the beneficiary the following year, and could reduce need-based aid by as much as 50%.
529 plans exclusively use mutual funds and offer two investment options. The first is an age-based portfolio option, similar to a target date retirement fund, where the investments shift from aggressive (high percentage of stocks) to conservative (high percentage of bonds and cash) as the beneficiary gets close to college age. The idea is that the portfolio increases the chance of gain early on and reduces the risk of loss later on. The second option is a static portfolio, where the funds stay the same over time, and the account owner rebalances as they see fit, up to once a year. Within both of these options you can still choose your risk tolerance and have a diversified portfolio. 529 plans are undeniably worth it – as JP Morgan Asset Management tracks it, even in its worst 18-year period, a 50/50 mix of stocks and bonds outperformed tuition inflation.
Lastly, a quick note about direct-sold versus advisor-sold plans. Advisor-sold plans have on average a 4.75% commission attached to them, increasing plan cost and cutting into plan returns. According to Morningstar, most 529 plan assets are invested in age-based portfolios, which are automatically rebalanced over time, and account owners tend to stick with this allocation. It makes you wonder, what is the need for an advisor then? In fact, Morningstar’s 2016 ranking of the best 529 plans overwhelmingly puts direct-sold plans at the top of the list.