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Planning for future college expenses with 529 accounts
Financial planning for families can involve multiple investment goals. The big ones usually are investing for retirement and for your children’s college expenses. With any investment strategy, once you have identified an investment goal, you will want to utilize the right investment account to achieve that goal. If investing for future college expenses is your goal, then one of the investment accounts you will want to utilize is called a 529 plan.
What is a 529 plan?
A 529 plan is a tax-favored account authorized by Section 529 of the Internal Revenue Code and sponsored by a state or educational institution. These plans have specific tax-saving features to them, compared with other taxable accounts, which are listed below. To begin with, there are two types of 529 plans: prepaid tuition plans and education savings plans. Every state has at least one type of 529 plan. Additionally, some private colleges sponsor a prepaid tuition plan.
Prepaid tuition plan
The first type of 529 account is a prepaid tuition plan. These let an account owner purchase college credits (or units) for participating colleges or universities at today’s prices to be used for the student’s future tuition charges. The states that sponsor prepaid plans do so primarily for the benefit of their in-state public colleges and universities. Things to know about the prepaid plans: States may or may not guarantee that the prepaid units keep up with increases in tuition charges. The plan also may have a state residency requirement. If the student decides not to attend one of the eligible schools, the equivalent payout may be less than had the student attended one of the participating institutions. There are no federal guarantees on the state prepaid plans and they are not available for private elementary and high school programs.
Education savings plan
The second type of 529 account is an education savings plan, an investment account into which you can invest your after-tax dollars. The intent with these accounts is to grow the balance for use at a future date. These are tax-deferred accounts, which means each year the interest, dividends, and capital gains created within the account do not show up on your tax return. If the funds are used for a “qualified” higher-education expense, then gains on the account are not taxed upon withdrawal.
As with most investments, the longer your money is invested, the more time it has to grow via accumulated interest, dividends, and appreciation. The larger the growth, the larger the tax benefits. This offers a tremendous advantage for a high-income and high-tax bracket household to invest for future goals (such as private school tuition or college expenses). By contrast, if you had invested in a fully taxable account, you would be subject to taxes each year on the interest, dividends, and capital gain distributions. Also, with taxable accounts, your investments would be subject to capital gains tax on the growth when they are sold to pay for those future expenses.
An account owner may choose among a range of investment options that the 529 plan provides. These are typically individual mutual funds or preformed mutual fund portfolios. The portfolios may have a fixed allocation percentage that stays the same over time or come “age-weighted,” meaning the investment allocation becomes more conservative the closer the student gets to college age when withdrawals would occur. This is a similar approach to the “target retirement date” offerings one sees in retirement accounts.
If one is using the 529 account for the student’s elementary or high school years, the investment time frame may be shorter and necessitate a more conservative approach, as the time for withdrawals would be nearer than the college years. As with most investments, the account can lose value based on investment performance.
Owner versus beneficiary
There are two parties to any 529 plan account: The account owner, who has control over the account and can name the beneficiary to the account, and the beneficiary (the student). The account owner can change beneficiaries on the account and can even name themselves as the beneficiary. One can name anyone as the beneficiary (e.g., child, friend, relative, yourself). You can be proactive by creating an account and naming yourself the beneficiary now, before switching to your child in the future. The account owner can live in one state with the beneficiary in another and invest in the 529 from a third state, and the student may eventually go to an educational institution in a fourth state. The 529 education savings account is not limited to any specific college, as a prepaid plan may be.
Withdrawals from 529s
If a 529 account withdrawal is for qualified higher education expenses or tuition for elementary or secondary schools, earnings are not subject to federal income tax or, in many cases, state income tax. Qualified withdrawals need to take place in the same tax year as the qualified expense.
Withdrawals not used for qualified higher education expenses in that year are considered “nonqualified” and would be subject to tax and 10% penalty on the earnings. State and local taxes may apply as well.
You can use the proceeds from the account free of taxes for the following qualified higher-education expenses:
- Tuition and school fees for both full and part time students at an eligible college, university, trade, or vocational institution.
- Room and board if the student is enrolled at more than half-time status. The amount up to the school’s room and board charges are eligible if paid directly to the school or to a landlord if living in nonschool housing. If actual charges to the landlord exceed the schools’ charges, then the amount above the school’s charges would be considered an excess withdrawal.
- Required books, supplies, and equipment for the academic program. Computer and technology equipment, printers, and required software, and such related services as Internet access also are qualified expenses.
- Private elementary or secondary school tuition up to $10,000 annually also is a qualified expense for 529 withdrawals.
Health insurance for the student and transportation-related costs to and from the school are not qualified expenses.
Contributions and fees
Like all investments, the fees associated with a 529 account need to be considered, as excess fees lower the investment returns. Prepaid tuition plans may charge initial application, transaction, and ongoing administrative fees. Investment 529 accounts may also have administrative costs such as program management fees, per-transaction fees, and the underlying investment expense ratios. Some states have broker-sold plans as well as direct-sold plans. Broker-sold plans can be purchased only through a broker and have the additional expenses associated with that either in the form of a load (sales charge) or higher expense ratio.
Contributions to a 529 plan can only be made in cash. If you currently have other investments, they need to be liquidated first (with the associated tax consequence) and then the proceeds invested into the 529 plan. Establishing the account and ongoing contributions are subject to gift tax limits ($15,000 for 2019). A married couple may make a “joint gift” to the account to double the limit. The 529 plans also allow the owner to front-load the account in 1 year with up to 5 years’ worth of gift limit contributions all at once. This lump sum is treated for tax reasons as a pro-rata 5 consecutive years of contributions all at once. Any additional gifts to that beneficiary during that year and the remaining four would be subject to gift tax issues if it means the annual gift limits were exceeded. Contributions are considered a “completed gift” for gift- and estate-tax purposes even though the account owner retains an element of control. The up-front 5-year gift election is available only on 529 accounts and is a great way for parents and grandparents (hint-hint) to reduce their estates and get a significant initial balance into the account. This can come in handy for those who may have procrastinated working toward this investment goal and need to catch up.
If the beneficiary does not need all or some of the funds for qualified higher education expenses, the account owner has options: One can change beneficiary to another relative who may need the funds or keep the account going and eventually add a grandchild as a beneficiary. Graduate school expenses also are eligible. A student can have multiple 529 accounts set up in their name.
Additional tax considerations
Education Tax Credits like the American Opportunity Tax Credit and the Lifetime Learning Credit have income phase-outs that you may or may not be eligible for based on your income. Education expenses used to qualify for the tax-free withdrawal from a 529 plan cannot be used to claim these tax credits. Several states offer state income tax deductions for contributions to a 529 plan but may have eligibility limited to the in-state plan only. It is wise to look to your own state’s plan first to see if that is the case and consider that as a factor when you choose a plan right for you. Refer to your tax professional for your eligibility.
In conclusion, 529 savings plans represent a tax-free way to grow your investments for future education expenses down the road, even if you don’t have a child yet. Speak to your financial adviser to learn about plans and contribution schedules that work with your current and future investing goals.
Good sources for further information include:
- www.savingforcollege.com.
- www.irs.gov/forms-pubs/about-publication-970.
- www.finra.org/investors/saving-college.
Mr. Clancy is director of financial planning, Drexel University College of Medicine.
Financial planning for families can involve multiple investment goals. The big ones usually are investing for retirement and for your children’s college expenses. With any investment strategy, once you have identified an investment goal, you will want to utilize the right investment account to achieve that goal. If investing for future college expenses is your goal, then one of the investment accounts you will want to utilize is called a 529 plan.
What is a 529 plan?
A 529 plan is a tax-favored account authorized by Section 529 of the Internal Revenue Code and sponsored by a state or educational institution. These plans have specific tax-saving features to them, compared with other taxable accounts, which are listed below. To begin with, there are two types of 529 plans: prepaid tuition plans and education savings plans. Every state has at least one type of 529 plan. Additionally, some private colleges sponsor a prepaid tuition plan.
Prepaid tuition plan
The first type of 529 account is a prepaid tuition plan. These let an account owner purchase college credits (or units) for participating colleges or universities at today’s prices to be used for the student’s future tuition charges. The states that sponsor prepaid plans do so primarily for the benefit of their in-state public colleges and universities. Things to know about the prepaid plans: States may or may not guarantee that the prepaid units keep up with increases in tuition charges. The plan also may have a state residency requirement. If the student decides not to attend one of the eligible schools, the equivalent payout may be less than had the student attended one of the participating institutions. There are no federal guarantees on the state prepaid plans and they are not available for private elementary and high school programs.
Education savings plan
The second type of 529 account is an education savings plan, an investment account into which you can invest your after-tax dollars. The intent with these accounts is to grow the balance for use at a future date. These are tax-deferred accounts, which means each year the interest, dividends, and capital gains created within the account do not show up on your tax return. If the funds are used for a “qualified” higher-education expense, then gains on the account are not taxed upon withdrawal.
As with most investments, the longer your money is invested, the more time it has to grow via accumulated interest, dividends, and appreciation. The larger the growth, the larger the tax benefits. This offers a tremendous advantage for a high-income and high-tax bracket household to invest for future goals (such as private school tuition or college expenses). By contrast, if you had invested in a fully taxable account, you would be subject to taxes each year on the interest, dividends, and capital gain distributions. Also, with taxable accounts, your investments would be subject to capital gains tax on the growth when they are sold to pay for those future expenses.
An account owner may choose among a range of investment options that the 529 plan provides. These are typically individual mutual funds or preformed mutual fund portfolios. The portfolios may have a fixed allocation percentage that stays the same over time or come “age-weighted,” meaning the investment allocation becomes more conservative the closer the student gets to college age when withdrawals would occur. This is a similar approach to the “target retirement date” offerings one sees in retirement accounts.
If one is using the 529 account for the student’s elementary or high school years, the investment time frame may be shorter and necessitate a more conservative approach, as the time for withdrawals would be nearer than the college years. As with most investments, the account can lose value based on investment performance.
Owner versus beneficiary
There are two parties to any 529 plan account: The account owner, who has control over the account and can name the beneficiary to the account, and the beneficiary (the student). The account owner can change beneficiaries on the account and can even name themselves as the beneficiary. One can name anyone as the beneficiary (e.g., child, friend, relative, yourself). You can be proactive by creating an account and naming yourself the beneficiary now, before switching to your child in the future. The account owner can live in one state with the beneficiary in another and invest in the 529 from a third state, and the student may eventually go to an educational institution in a fourth state. The 529 education savings account is not limited to any specific college, as a prepaid plan may be.
Withdrawals from 529s
If a 529 account withdrawal is for qualified higher education expenses or tuition for elementary or secondary schools, earnings are not subject to federal income tax or, in many cases, state income tax. Qualified withdrawals need to take place in the same tax year as the qualified expense.
Withdrawals not used for qualified higher education expenses in that year are considered “nonqualified” and would be subject to tax and 10% penalty on the earnings. State and local taxes may apply as well.
You can use the proceeds from the account free of taxes for the following qualified higher-education expenses:
- Tuition and school fees for both full and part time students at an eligible college, university, trade, or vocational institution.
- Room and board if the student is enrolled at more than half-time status. The amount up to the school’s room and board charges are eligible if paid directly to the school or to a landlord if living in nonschool housing. If actual charges to the landlord exceed the schools’ charges, then the amount above the school’s charges would be considered an excess withdrawal.
- Required books, supplies, and equipment for the academic program. Computer and technology equipment, printers, and required software, and such related services as Internet access also are qualified expenses.
- Private elementary or secondary school tuition up to $10,000 annually also is a qualified expense for 529 withdrawals.
Health insurance for the student and transportation-related costs to and from the school are not qualified expenses.
Contributions and fees
Like all investments, the fees associated with a 529 account need to be considered, as excess fees lower the investment returns. Prepaid tuition plans may charge initial application, transaction, and ongoing administrative fees. Investment 529 accounts may also have administrative costs such as program management fees, per-transaction fees, and the underlying investment expense ratios. Some states have broker-sold plans as well as direct-sold plans. Broker-sold plans can be purchased only through a broker and have the additional expenses associated with that either in the form of a load (sales charge) or higher expense ratio.
Contributions to a 529 plan can only be made in cash. If you currently have other investments, they need to be liquidated first (with the associated tax consequence) and then the proceeds invested into the 529 plan. Establishing the account and ongoing contributions are subject to gift tax limits ($15,000 for 2019). A married couple may make a “joint gift” to the account to double the limit. The 529 plans also allow the owner to front-load the account in 1 year with up to 5 years’ worth of gift limit contributions all at once. This lump sum is treated for tax reasons as a pro-rata 5 consecutive years of contributions all at once. Any additional gifts to that beneficiary during that year and the remaining four would be subject to gift tax issues if it means the annual gift limits were exceeded. Contributions are considered a “completed gift” for gift- and estate-tax purposes even though the account owner retains an element of control. The up-front 5-year gift election is available only on 529 accounts and is a great way for parents and grandparents (hint-hint) to reduce their estates and get a significant initial balance into the account. This can come in handy for those who may have procrastinated working toward this investment goal and need to catch up.
If the beneficiary does not need all or some of the funds for qualified higher education expenses, the account owner has options: One can change beneficiary to another relative who may need the funds or keep the account going and eventually add a grandchild as a beneficiary. Graduate school expenses also are eligible. A student can have multiple 529 accounts set up in their name.
Additional tax considerations
Education Tax Credits like the American Opportunity Tax Credit and the Lifetime Learning Credit have income phase-outs that you may or may not be eligible for based on your income. Education expenses used to qualify for the tax-free withdrawal from a 529 plan cannot be used to claim these tax credits. Several states offer state income tax deductions for contributions to a 529 plan but may have eligibility limited to the in-state plan only. It is wise to look to your own state’s plan first to see if that is the case and consider that as a factor when you choose a plan right for you. Refer to your tax professional for your eligibility.
In conclusion, 529 savings plans represent a tax-free way to grow your investments for future education expenses down the road, even if you don’t have a child yet. Speak to your financial adviser to learn about plans and contribution schedules that work with your current and future investing goals.
Good sources for further information include:
- www.savingforcollege.com.
- www.irs.gov/forms-pubs/about-publication-970.
- www.finra.org/investors/saving-college.
Mr. Clancy is director of financial planning, Drexel University College of Medicine.
Financial planning for families can involve multiple investment goals. The big ones usually are investing for retirement and for your children’s college expenses. With any investment strategy, once you have identified an investment goal, you will want to utilize the right investment account to achieve that goal. If investing for future college expenses is your goal, then one of the investment accounts you will want to utilize is called a 529 plan.
What is a 529 plan?
A 529 plan is a tax-favored account authorized by Section 529 of the Internal Revenue Code and sponsored by a state or educational institution. These plans have specific tax-saving features to them, compared with other taxable accounts, which are listed below. To begin with, there are two types of 529 plans: prepaid tuition plans and education savings plans. Every state has at least one type of 529 plan. Additionally, some private colleges sponsor a prepaid tuition plan.
Prepaid tuition plan
The first type of 529 account is a prepaid tuition plan. These let an account owner purchase college credits (or units) for participating colleges or universities at today’s prices to be used for the student’s future tuition charges. The states that sponsor prepaid plans do so primarily for the benefit of their in-state public colleges and universities. Things to know about the prepaid plans: States may or may not guarantee that the prepaid units keep up with increases in tuition charges. The plan also may have a state residency requirement. If the student decides not to attend one of the eligible schools, the equivalent payout may be less than had the student attended one of the participating institutions. There are no federal guarantees on the state prepaid plans and they are not available for private elementary and high school programs.
Education savings plan
The second type of 529 account is an education savings plan, an investment account into which you can invest your after-tax dollars. The intent with these accounts is to grow the balance for use at a future date. These are tax-deferred accounts, which means each year the interest, dividends, and capital gains created within the account do not show up on your tax return. If the funds are used for a “qualified” higher-education expense, then gains on the account are not taxed upon withdrawal.
As with most investments, the longer your money is invested, the more time it has to grow via accumulated interest, dividends, and appreciation. The larger the growth, the larger the tax benefits. This offers a tremendous advantage for a high-income and high-tax bracket household to invest for future goals (such as private school tuition or college expenses). By contrast, if you had invested in a fully taxable account, you would be subject to taxes each year on the interest, dividends, and capital gain distributions. Also, with taxable accounts, your investments would be subject to capital gains tax on the growth when they are sold to pay for those future expenses.
An account owner may choose among a range of investment options that the 529 plan provides. These are typically individual mutual funds or preformed mutual fund portfolios. The portfolios may have a fixed allocation percentage that stays the same over time or come “age-weighted,” meaning the investment allocation becomes more conservative the closer the student gets to college age when withdrawals would occur. This is a similar approach to the “target retirement date” offerings one sees in retirement accounts.
If one is using the 529 account for the student’s elementary or high school years, the investment time frame may be shorter and necessitate a more conservative approach, as the time for withdrawals would be nearer than the college years. As with most investments, the account can lose value based on investment performance.
Owner versus beneficiary
There are two parties to any 529 plan account: The account owner, who has control over the account and can name the beneficiary to the account, and the beneficiary (the student). The account owner can change beneficiaries on the account and can even name themselves as the beneficiary. One can name anyone as the beneficiary (e.g., child, friend, relative, yourself). You can be proactive by creating an account and naming yourself the beneficiary now, before switching to your child in the future. The account owner can live in one state with the beneficiary in another and invest in the 529 from a third state, and the student may eventually go to an educational institution in a fourth state. The 529 education savings account is not limited to any specific college, as a prepaid plan may be.
Withdrawals from 529s
If a 529 account withdrawal is for qualified higher education expenses or tuition for elementary or secondary schools, earnings are not subject to federal income tax or, in many cases, state income tax. Qualified withdrawals need to take place in the same tax year as the qualified expense.
Withdrawals not used for qualified higher education expenses in that year are considered “nonqualified” and would be subject to tax and 10% penalty on the earnings. State and local taxes may apply as well.
You can use the proceeds from the account free of taxes for the following qualified higher-education expenses:
- Tuition and school fees for both full and part time students at an eligible college, university, trade, or vocational institution.
- Room and board if the student is enrolled at more than half-time status. The amount up to the school’s room and board charges are eligible if paid directly to the school or to a landlord if living in nonschool housing. If actual charges to the landlord exceed the schools’ charges, then the amount above the school’s charges would be considered an excess withdrawal.
- Required books, supplies, and equipment for the academic program. Computer and technology equipment, printers, and required software, and such related services as Internet access also are qualified expenses.
- Private elementary or secondary school tuition up to $10,000 annually also is a qualified expense for 529 withdrawals.
Health insurance for the student and transportation-related costs to and from the school are not qualified expenses.
Contributions and fees
Like all investments, the fees associated with a 529 account need to be considered, as excess fees lower the investment returns. Prepaid tuition plans may charge initial application, transaction, and ongoing administrative fees. Investment 529 accounts may also have administrative costs such as program management fees, per-transaction fees, and the underlying investment expense ratios. Some states have broker-sold plans as well as direct-sold plans. Broker-sold plans can be purchased only through a broker and have the additional expenses associated with that either in the form of a load (sales charge) or higher expense ratio.
Contributions to a 529 plan can only be made in cash. If you currently have other investments, they need to be liquidated first (with the associated tax consequence) and then the proceeds invested into the 529 plan. Establishing the account and ongoing contributions are subject to gift tax limits ($15,000 for 2019). A married couple may make a “joint gift” to the account to double the limit. The 529 plans also allow the owner to front-load the account in 1 year with up to 5 years’ worth of gift limit contributions all at once. This lump sum is treated for tax reasons as a pro-rata 5 consecutive years of contributions all at once. Any additional gifts to that beneficiary during that year and the remaining four would be subject to gift tax issues if it means the annual gift limits were exceeded. Contributions are considered a “completed gift” for gift- and estate-tax purposes even though the account owner retains an element of control. The up-front 5-year gift election is available only on 529 accounts and is a great way for parents and grandparents (hint-hint) to reduce their estates and get a significant initial balance into the account. This can come in handy for those who may have procrastinated working toward this investment goal and need to catch up.
If the beneficiary does not need all or some of the funds for qualified higher education expenses, the account owner has options: One can change beneficiary to another relative who may need the funds or keep the account going and eventually add a grandchild as a beneficiary. Graduate school expenses also are eligible. A student can have multiple 529 accounts set up in their name.
Additional tax considerations
Education Tax Credits like the American Opportunity Tax Credit and the Lifetime Learning Credit have income phase-outs that you may or may not be eligible for based on your income. Education expenses used to qualify for the tax-free withdrawal from a 529 plan cannot be used to claim these tax credits. Several states offer state income tax deductions for contributions to a 529 plan but may have eligibility limited to the in-state plan only. It is wise to look to your own state’s plan first to see if that is the case and consider that as a factor when you choose a plan right for you. Refer to your tax professional for your eligibility.
In conclusion, 529 savings plans represent a tax-free way to grow your investments for future education expenses down the road, even if you don’t have a child yet. Speak to your financial adviser to learn about plans and contribution schedules that work with your current and future investing goals.
Good sources for further information include:
- www.savingforcollege.com.
- www.irs.gov/forms-pubs/about-publication-970.
- www.finra.org/investors/saving-college.
Mr. Clancy is director of financial planning, Drexel University College of Medicine.