529 Plans – Parents’ Best Friend

Higher education costs in the US have been on a steep rise for many years, causing parents moderate to severe panic attacks. It seems unlikely that this trend will reverse or even stop in the foreseeable future. After all it is not possible to outsource college to China, like the manufacturing of gadgets. 

But fortunately parents, and for that matter relatives, have a rather powerful tool to help them fund the education bills of their students. Congress has given us the 529 Plans, one of the best options available for education and estate planning. What makes these plans so attractive are their generous contribution limits, tax treatment, and flexibility.

What are those plans and how does one get started?

The 529 Plans are administered by the states. States in turn contract asset management companies to manage the assets in the plan. There are different investment options available, and participants can choose what suits them best given their risk tolerance level and investment objectives. 

Any US citizen 18 years or older can open a 529 Plan account and become Account Owner. Minimum contributions are usually quite small. Once the account is established anyone can make contributions to the account, but the Account Owner only can direct the investments. Importantly,  other persons (not just the parents) can establish and fund accounts for a child. For instance, grandparents can establish 529 Plan accounts for their grandchildren. What is more, non-parents’ accounts are not included in the family assets for FAFSA application purposes. FAFSA requires only parents’ 529 Plans to be reported in order to determine financial aid eligibility. The Account Owner needs to designate a Beneficiary (the potential student). The Beneficiary does not have to be a family member. Any US citizen or resident alien can be named as a Beneficiary. That makes for some pretty interesting gifting opportunities.

How much money can I squirrel away?

Current maximum contribution is $18,000 per account per year. (Contributions beyond that will trigger gift tax and need to be reported to the IRS.) Compared to the $7,000 contribution limit to an IRA account for instance, this is rather sizeable. Even better, one can “superfund” five-years’ worth of contributions, or $90,000 per account, all at once without triggering gift tax as long as no further contributions are made for the next five years.

There is a limit to the total contributions one can make into an account which varies by state. Some are in the $200,000s range, but others allow more than $500,000. Once the limit is reached no more contributions are allowed, but the money in the account can continue to grow from capital gains, dividends, and interest. 

What is the tax treatment of the 529 Plans?

The tax treatment of 529 Plans is quite favorable. While contributions are not tax deductible at federal level, most states allow for tax deductions. The money grows in the account tax-free. Qualified Withdrawals (i.e., to pay for Qualified Expenses) are also tax-free. For Non-Qualified Withdrawals, the earnings portion of the account is treated as income and is subject to the applicable federal and state taxes, plus an additional 10% federal tax penalty. There are certain cases in which the 10% penalty is waived, however. 

Qualified Expenses can be for higher education or for K-12. For higher education, those include tuition, books, study-related equipment (i.e., computer), as well as campus-based living expenses. Up to $10,000 can be used to repay qualified education loans of the Beneficiary or his/her sibling. Qualified Expenses for K-12 education are limited to $10,000 per tax year per beneficiary from all 529 plans. 

Why is it worth shopping around for a 529 Plan?

The 529 Plans are administered at a state level. However, one can open a 529 Plan in any state, regardless of one’s state of residence. Different state plans vary by account limits, investment options, fees, etc. One should shop around and consider different plans based on the following factors:

• If the person’s state of residence allows for tax-free contributions or not. 
• The account contribution limit. Different states have different limits on the size of each account, as discussed earlier. 
• Investment options. Different plans may offer different investment options. 
• Historical performance of the investment options.
• Fees and other costs. Plans have different investment and administrative fees. The lower the fees, the better. 

Why are 529 Plans powerful saving tools?

Let’s do a quick math. Hypothetically, two parents are saving for their child’s college education. They superfund total of $180,000 in two accounts when the child is born, and make no further contributions thereafter. They have about 18 years for their money to grow  (practically, it’s more than 18 years as not the entire amount is due upfront). The $180,000 left alone to grow for 18 years at a relatively conservative 5% per year tax-free will become $433,191. That’s a pretty tidy sum of money.

Of course, not all young parents can easily produce $180,000 to fund the accounts upfront. Let’s look at an example with annual contributions. If we assume that future cost of 4-year college education in 18 years will average $300,000 (double the current $150,000 average cost), then how much do they have to contribute each year to fund this amount in 18 years, if their money earns 5% per year tax-free? It turns out that annual contribution needed is just over $10,000, or $5,000 per account. Notice that the total contribution in this case also totals about $180,000, but spread over time. While still meaningful, this is much more manageable given that cash outflows are spread out. 

The bottom line is that thanks to the combination of the ability to contribute sizeable amounts, the relatively long time horizon, the tax-free status of the money in the account, and the power of compounding, the parents’ savings will work extra hard and market gains will make a sizeable contribution to the college funding no matter how one funds the account. The important thing is to start as early as possible. 

Why are 529 Plans powerful estate planning tools?

As we mentioned above, the law allows great flexibility as to who can be Account Owner and who can be Beneficiary. But that’s not all. The Beneficiary can be changed without tax consequences, as long as the new Beneficiary is a Family Member (as defined by the law) of the original one. Family Members are defined broadly and include ancestors, descendants, siblings, children of siblings, spouses, some in-laws, as well as first cousins. The Account Owner can also transfer the assets of one account to the account of another beneficiary who is Family Member of the prior beneficiary without any federal tax consequences. 

Further, the Account Owner may transfer assets out of the 529 Account to a Roth IRA maintained for the benefit of the Beneficiary with no tax consequences under certain conditions. At federal level, some of these (but not all) are: 

• The account must have been open for at least 15 years 
• Funds subject to transfer must have been held in the account for at least 5 years
• Lifetime maximum rollout per beneficiary is limited to $35,000. 
• Rollover is subject to annual Roth IRA contribution limits
• Funds must be sent directly in a trustee to trustee transfer

Imagine that you funded a 529 account for your child, but there is money left in the accounts after they are done with college. You can keep the money and designate your grandchildren (or other Family Members) as the new Beneficiaries for their college funding needs. In the meantime, the assets grow tax free until the college bills are due. Or you can fund your child's Roth IRA account. It's a win-win.

So even if one is not certain that one’s child will go to college, it still makes sense to open a 529 Plan account and contribute given the tax-advantaged nature and the great flexibility that these accounts offer. It’s one of the better and easier estate planning tools out there. 

Mihail Dobrinov, CFA

Trimon Capital 

mihail.dobrinov@trimoncapital.com

(941)-287-5987

Disclosures: This report is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Past performance is not indicative of future results.