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A Good Plan Just Got Better

| March 15, 2018
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The cost of a college education can be staggering. Expenses at private universities currently average more than $50,000 a year1. The annual cost for state colleges averages about $40,0001. For many families, qualified tuition programs — also called Section 529 education savings plans — are attractive ways to help meet future education expenses.

How Section 529 Plans Work

Section 529 plans are education savings programs sponsored by most states under Section 529 of the Internal Revenue Code. Beginning in 2002, private educational institutions have been able to sponsor prepaid tuition programs. You can contribute to a Section 529 plan regardless of your annual income or your age, and your contributions can be for the benefit of a grandchild, niece, nephew, or other individuals, as well as your own child.

With a 529 plan, you either invest a lump sum or make periodic contributions to an account set up for a designated beneficiary. While different programs do place limits on lifetime contributions, most limits are in excess of $100,000, and some are greater than $200,000. The plan account is professionally managed according to the parameters established under the applicable 529 plan. When the beneficiary of the account is ready for college, generally you — not the beneficiary — withdraw the amount needed to pay qualified education expenses, such as tuition, room and board, supplies, and equipment.

Tax Advantages

Money invested in Section 529 plans grows free of federal income tax and possibly state income tax for participating residents in many states. Some states also allow you to deduct contributions in Section 529 plans for state income-tax purposes, up to certain limits, if you participate in your own state’s program. In addition, 529 plans permit reallocation of investments as needed (subject to plan limitations) with no capital gains tax consequences, something you can’t do with a regular investment account.

Since 2002, payouts from qualified state plans are tax free, and payouts from all Section 529 plans will be excludable from income if used for qualified expenses. (Note that after 2001 tax- free withdrawals cannot be used for the same expenses for which HOPE or Lifetime Learning Credits are claimed.) Withdrawals for anything other than qualified education expenses are subject to income taxes and may be subject to an additional 10% federal tax penalty.

Investments in Section 529 plans qualify for the federal gift-tax annual exclusion. For taxable year 2018, this exclusion lets you make tax-free gifts of up to $15,000 a year ($30,000 if your spouse agrees to join in your gifts) to each of as many people as you choose. A special tax provision allows you to contribute up to $75,000 in one year and treat the contribution as if it were made over five years so it qualifies for the exclusion. So, for example, you and your spouse could contribute as much as $150,000 in one year for each of your children or grandchildren (or other beneficiaries for that matter, free of gift tax.

The money you invest in a 529 plan, as well as all future appreciation on that money, generally is removed from your estate for estate-tax purposes. However, if you make the five-year/$75,000 election, and die within five years of the election, a prorated portion of the contribution could be included in your estate. Using the annual exclusion to make gifts to grandchildren has generation- skipping transfer (GST) tax advantages, too. No GST tax will be applied to contributions that qualify for the annual exclusion.

After Congress' rewrite of the Tax Code late 2017, 529 plans may cover tuition not only at colleges and universities, but also at private elementary and high schools. But, before you jump to withdraw from an account to pay for a private prep school, beware: You could wind up taking a significant financial hit by doing so. That’s because several states first need to update their own statues in order to let account holders keep all the existing benefits of saving in a 529 account while using the money for K-12 education. If you live in certain states and you withdraw funds before that happens, you may risk having to repay a state tax deduction you’ve already received—or facing state tax on the investment gains in attributable to the distribution.

Portability

Since 2002, money can be transferred tax free from one qualified tuition program to another qualified tuition program for the same beneficiary. Other transfer rules vary from state to state. In case the designated child decides not to attend college, you have the option of changing the account beneficiary to another family member. Family members include the beneficiary’s spouse, siblings, first cousins, children, nieces, nephews, and their spouses. Take care, though, when changing beneficiaries. Gift and GST taxes could apply if the new beneficiary you name is a generation below the old beneficiary.

Financial Aid

On the minus side, a Section 529 plan account may adversely affect your child’s ability to qualify for need-based financial aid. The 529 plans owned by college students or their parents count as assets and reduce need-based aid by a maximum of 5.64% of the asset’s value. Withdrawals from Section 529 plan accounts generally are counted as student income. Many aid formulas consider up to 50% of student income available for tuition. However, aid is often granted as loans, which you may want to avoid. Most families earning $100,000 or more qualify for very little need-based aid.

Choosing the Right Plan

To find out which states offer qualified tuition programs and get general information about them, check: www.savingforcollege.com or http://plans.collegesavings.org/viewState.aspx. Carefully refer to the program brochure or offering memorandum and prospectus for complete investment information on objectives, risks, fees and expenses. These documents should be read carefully before investing. Note that your choice isn’t limited to the program offered by your home state.

The risk with investing for college is that the investments may not perform well enough to cover the rising cost of college expenses, as anticipated. The investment return and principal value of an investment will fluctuate with changes in market conditions so that an investor’s shares when redeemed may be worth more or less than the original invested. However before choosing a plan, you should talk with a professional financial planner. He or she can help you evaluate the many programs available.lable.

1 Sample Average Undergraduate Budgets, 2017-18, Trends in College Pricing, The College Board https://trends.collegeboard.org/college-pricing/figures-tables/average-estimated-undergraduate-budgets-2017-18

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