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Tax Tip of the Week | 529 Plans June 5, 2019

Posted by bradstreetblogger in : Deductions, General, tax changes, Tax Planning Tips, Tax Preparation, Tax Tip, Taxes, Uncategorized , trackback

529 PLANS are confusing! And, that is an understatement…especially since on the surface they seem sooooooooo straightforward. But once you look behind the curtain one can start to see their turns and twists along the way with some far-reaching complications that are rarely considered. Personally, I think their tax savings feature is overrated in many cases…BUT having said that, I am not sure of many better ways to save for someone’s education including that of your grandchildren. American families currently have $329 billion in 529 Plans. Hopefully, these 529 Plans will reduce the need for students’ loans. That would be a blessing!  

Chana R. Schoenberger wrote the following article (The 6 Biggest Questions about ‘529’ Plans) for the WSJ as published on Monday, March 4, 2019.  

                                      –    Mark Bradstreet

Four years ago, we started answering readers’ questions on saving and paying for higher education, especially about how best to use tax-advantaged “529” accounts.

In all, we have answered more than 200 questions, with the help of experts. But readers’ questions continue to pour in, in part because the rules about 529s are so confusing—and keep changing. For instance, families are now allowed to use 529 money to pay for private K-12 schooling, not just college. And the Fafsa financial-aid process now looks back two years, not one, at student income when determining aid.

To mark this column’s fourth anniversary, we revisited six recurring 529 questions that we receive in readers’ emails. We asked two experts to help answer these greatest-hits questions: Michael Frerichs, the state treasurer of Illinois and vice chairman of the College Savings Plans Network, an association of state 529 plan administrators; and Mark Kantrowitz, the publisher and vice president of research at Miami-based Savingforcollege.com.

What is the advantage of 529s over other ways of saving for college?

Experts say that 529 accounts are still one of the best ways to save for college, mainly because of the tax benefits.

When you deposit money in a 529 account, it is considered a gift to the beneficiary. It grows tax-free in the account until you withdraw it for the beneficiary’s qualified educational expenses, which can include tuition, room and board, a computer and certain expenses. If you follow these rules, you don’t incur any tax, state or federal, on withdrawals. Some states also offer tax deductions or credits for investing money in a 529, Mr. Frerichs says. (In some cases, residents must invest in their own state’s plan; other states confer these benefits on any resident contributing to any plan.)

There are other benefits. Anyone can contribute, putting in up to $15,000 annually before paying taxes. You can also pre-fund an account, putting in up to $75,000 ($150,000 for married couples filing jointly) at one time and choosing to use up to five years’ worth of your annual pretax limit, Mr. Frerichs says.

What’s more, “most plans have very low minimum-contribution limits, and most accounts are protected from creditors’ claims in bankruptcy, making them attractive to families regardless of income level,” says Mr. Frerichs.

If my child ends up not using all the money in the 529 for educational purposes, how can we withdraw it or use it?

This is one of the most advantageous features of a 529 account: “There is no time limit on when the money in a 529 plan must be used, so you could just keep the money in the 529 plan account, earning tax-free returns,” Mr. Kantrowitz says.

Your child may wish to go to graduate school later on. You also have the option to switch the beneficiary of the account to any of the original beneficiary’s direct relatives, including siblings, cousins or even yourself.

“You don’t need to be pursuing a degree or certificate, so you can use 529 plan money to pay for continuing education,” Mr. Kantrowitz says.

If you leave the money in the account, your grandchildren could one day use it—even if they aren’t yet born today.

“A 529 plan is a great way of leaving a legacy for future generations,” he says.

If you choose to take the money out of the account without using it for qualified educational purposes, you will incur a 10% federal penalty on the gains portion of any withdrawals, plus federal and state income tax on gains, says Mr. Frerichs. Some plans may also charge extra fees or penalties if you withdraw money in this manner, he says.

You won’t have to pay the penalties if you withdraw the money because your child has received a scholarship or because you’re using the American Opportunity Tax Credit for higher education, Mr. Kantrowitz says. But you may have to repay any state-tax benefits you’ve received if you make a nonqualified withdrawal.

What is the best way to have a 529 account for financial-aid purposes: owned by the grandparents or owned by the parents?

“From a financial-aid perspective, it is generally better to have a 529 plan be owned by the student’s parents than the grandparents,” Mr. Kantrowitz says. You can work around this, but it is complex.

The key here is understanding the way that financial aid is computed. Most colleges use the federal government’s standardized Fafsa (Free Application for Federal Student Aid) online application to decide how much money a family can afford to pay for college—the Expected Family Contribution, or EFC—and how much they will need in scholarships or loans. (Some colleges use a different form, the CSS Profile.)

$329 billion?

The amount that American families have in ‘529’ plans, or an average $24,153 an account.

—College Savings Plans Network

“The smaller the percent value included in the EFC, the greater the potential financial aid,” Mr. Frerichs says.

Colleges make this decision by scrutinizing a family’s income and assets as well as their obligations, such as the number of other children they have in college. When they look at 529s, they note the ownership of the account. If a parent owns the account, or if it is a custodial 529 with the parent as custodian, the account is considered at 5.64% of its value. That is much lower than an account the student owns outright, such as an UGMA or UTMA savings or brokerage account, which would be considered at 20%, Mr. Frerichs says.

If anyone else owns the 529 account, whether it is a grandparent or any other person, that account doesn’t show up on the FAFSA as an asset at all. But when the student begins withdrawing money from the account to pay for school, the money is considered untaxed income on the following year’s FAFSA. That will cut financial-aid eligibility by as much as half of the withdrawal, Mr. Kantrowitz says.

For instance, he says, $10,000 in a parent-owned 529 plan might reduce aid eligibility by as much as $564, which is a lot less than the $5,000 reduction in financial aid for $10,000 in a grandparent-owned 529 plan when the student begins making withdrawals.

If you have a grandparent-owned account and want to get around this problem, there are some fixes. You can switch the account owner to the parent, although some plans don’t allow this unless the original owner has died.

You can wait until you’ve filed the FAFSA, then roll over a year’s worth of distributions from your grandparent-owned 529 into a parent-owned one in the same state’s plan (otherwise, you risk sparking state-tax consequences).

“If you wait until after the FAFSA is filed and use the money before the next FAFSA, it will have no impact on aid eligibility,” Mr. Kantrowitz says.

You can also withdraw money for a qualified expense after Jan. 1 of the student’s sophomore year (if the student plans to finish in four years; otherwise, do this two years before the student intends to graduate). The FAFSA looks back two years, so this will mean that the grandparent-owned plan won’t affect financial aid for college at all. However, this strategy won’t work if the student plans to apply for financial aid for graduate school right after finishing college, he warns.

You always have the option to take the money out of a grandparent’s 529 after college is finished and use it to pay off student loans, but that is an unqualified expense, so expect to pay the penalties and taxes on the earnings portion, he says.

How can we maximize our child’s eligibility for financial aid while still saving as much as we are able to pay for college?

Your best bet here is to use a 529 with the parent as the owner and the student as the beneficiary. “In particular, the money is reported as a parent asset on the FAFSA, so you’re no worse off from a financial-aid perspective than if you had saved in a taxable account in the parent’s name, though you do have significant tax savings,” Mr. Kantrowitz says.

One way to save for college without any impact on financial aid is to open a Roth IRA or qualified annuity in the student’s name. These are treated like grandparent-owned 529s: They’re not counted as assets on the FAFSA, but once you withdraw money to pay for college, it is considered untaxed income to the student, and counted at up to 50%, even if your withdrawal is a tax-free return of Roth IRA contributions, Mr. Kantrowitz says.

The benefit of a Roth IRA for this purpose is it hedges against the possibility that your student won’t go to college; this way, at least you’ll have started saving for the student’s eventual retirement in a tax-advantaged manner.

If your student comes into a large amount of money suddenly, and you’d like to get it out of the FAFSA’s view, annuities are the easiest way. Qualified annuities are ignored as assets on the Fafsa.

“Or invest the money in a small business that is owned and controlled by the family, taking advantage of the small-business exclusion on the Fafsa,” Mr. Kantrowitz says.

Note that these considerations don’t mean that you are better off not saving for college, on the hope that the college will give your student a scholarship. Scholarships are unusual, and full scholarships extremely rare. If you want to avoid student loans, to the extent possible, you should save as much as you can, even if it means your EFC is a bit higher than it would otherwise be.

“It is important to note that saving for college is highly beneficial and will have very limited impact on any potential financial aid,” Mr. Frerichs says.

Is it advisable to use 529 money for K-12 schooling, or should we save it for college?

It is certainly your option, under the new tax law, to use the money for private kindergarten-to-12 tuition and some expenses (though some states aren’t yet conforming to that federal change, as far as state taxes). But this negates the main benefit of 529s.

“529 plans are most attractive to parents because they can save for a longer period of time and prepare for the rising costs of higher-education expenses,” Mr. Frerichs says.

Some people think that sending their children to private school will help their chances of winning a college scholarship. But that is only partially true, Mr. Kantrowitz says. Private-high-school graduates win on average about $1,000 more in scholarships to college, but they’re also more likely to enroll at private colleges, which are more expensive than public colleges. This means that spending family 529 money to pay for private school won’t necessarily mean that the student will face smaller tuition bills for college.

Because your earnings will compound over time, you should start by saving for college first so your money will have time to grow, he says. You would also want a different mix of investments for K-12 school and for college, since you might wish to downshift the riskiness of your investments as tuition bills get closer. If you choose to use 529 money for a K-12 school, you might consider opening two separate 529 accounts for your student, so you can change the investment mix, Mr. Kantrowitz says.

The Savingforcollege.com site has a calculator you can use to explore the trade-offs.

What are the consequences if I change the owner of a 529 account?

Most plans permit the owner to name a successor in case of death, and some also allow a joint account owner.

If your plan permits you to change ownership, note that such a change might affect your student’s eligibility for financial aid (see question above). The owner is the person who holds full control over the beneficiary’s money in the account, so be careful to choose an owner you trust if it isn’t yourself, Mr. Kantrowitz says.

For plans that don’t allow ownership changes, you could roll over the balance of your 529 into a different 529 for the benefit of the same student or a member of the beneficiary’s family. It is also possible to do this manually, by taking a distribution from the original account and contributing it to another account within 60 days, Mr. Kantrowitz says. You may need to locate both accounts in the same state for tax purposes.

Be careful that the new account represents the rollover money correctly, with the new statement showing what money you contributed and what was gains, he says.

Credit Given to:  Chana R. Schoenberger. Ms. Schoenberger is a writer in New York. She can be reached at reports@wsj.com. This appeared in the March 4, 2019, print edition as ‘What You Need to Know About the New Tax Law and The 6 Biggest Questions About ‘529’ Plans.’

Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.  

This Week’s Author – Mark Bradstreet, CPA

–until next week.

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