529 Plans: An Essential Piece of College Tuition Planning
College tuition costs are at an all time high. Students obtaining advanced degrees may leave college with debt equivalent to a home mortgage. Although careful financial planning should be undertaken to save for potential college expenses, these savings can be enhanced if structured in a 529 plan. A529 plan (named for the section in the Internal Revenue Code authorizing the tax treatment of such plans) is a simple federal income tax strategy that may offer substantial benefits to families looking for ways to make a child’s college expenses more affordable.
Although 529 plans are funded with after-tax dollars, there are two significant tax benefits of a 529 plan which enhance a family’s educational savings. First, many states allow a tax deduction for contributions to a 529 plan. Not all states provide a deduction, and many states limit the amount of the deduction. For example, Illinois provides a state income tax deduction up to $10,000 for a single filer or $20,000 for a married couple. Secondly, the appreciation and growth of the funds in the accounts are not subject to federal or state income tax.So if contributions totaling $20,000 in years 1-5 grow to $100,000 by year 18, the $80,000 in growth escapes all federal income tax.
There are two types of 529 plans: savings plans and prepaid plans.A savings plan, as the name suggests, works like a typical savings account. After a savings plan is funded, the account balances start to accrue interest tax free. The account balances may be withdrawn and used for qualified expenses once the beneficiary incurs any qualified expenses. Under Section 529(e)(3), “qualified expenses” include tuition, fees, room and board, computers, books, supplies, and even expenses related to special needs. The benefit of a savings plan is the tax free accrual of interest on account balances. Thus, this benefit is maximized when a savings plan is funded years before the prospective student attends college.
Prepaid plans offer education on a later date at today’s prices. The contributor pays for course units or a percentage of tuition at current rates, which the beneficiary is entitled to at a later date. Therefore, prepaid plans usually limit qualifying expenses to tuition and fees. Only a few states offer prepaid plans. Prepaid plans impose greater limitations but, with shrewd planning, provide greater benefit.A prepaid plan offers the benefits of paying older cheaper tuition rates, minimizing the risk of inflation, and minimizing riskof future tax hikes. Furthermore, most prepaid plans are guaranteed by the state or educational institution offering the plan. In this case, a beneficiary will be entitled to the education purchased despite education costs or inflation surpassing anticipated levels, or if the account investments fail. However, use of prepaid plan funds are very limited, usually only to an in-state public university of the state offering the plan, or to the college offering the plan.
Another benefit of 529 plans are the flexibility. A 529 plan’s beneficiary can be a child, a sibling, niece or nephew, or even the account holder. Account balances can be rolled over, tax free, to a new plan for the same beneficiary or to a plan with another designated beneficiary. For example, a business owner with multiple children may rollover any unused funds from an older sibling’s account to that of the younger sibling.
Federal law does not limit the amount of contributions to a 529 plan. However, since a contribution by a grandparent or parent on behalf of a child will be classified as a gift, contributions should be limited to the annual gift tax exclusion ($14,000 in 2017). Section 529(c)(2)(B) does include a special provision allowing an individual to make a lump-sum contribution to a 529 plan in an amount equal to five times the federal annual gift tax exclusion ($70,000 or$140,000 for a married couple) per child,as long as the donor (the parent or grandparent in most cases) make an election on their federal gift tax return to allocate the gift evenly over a five-year period. This election is made on Form 709, Schedule A, Line B. If this election is made, the donor cannot not make another gifts to the same recipient during the five-year period without incurring gift tax consequences.
Additionally, contributions should be limited to what the prospective student will need for college. 529 plan funds may only be used for qualified expenses.Under Section 529(c)(6) and Section 530(d)(4), a penalty of 10 percent will be imposed on 529 funds used for expenses other than those designated as qualified expenses by the plan.
States and educational institutions were given autonomy by the federal government to develop their own 529 plans in an open market. This fostered the establishment of highly competitive plans. Plans are generally not limited to in-state residents, but some states allow in-state residents to deduct all or part of contributions made to in-state plans from their state income tax. Each state and some educational institutions can have a number of plans. State-to-state income tax and plan benefits can vary greatly, so it is wise to shop around.
