Pros and Cons of 529 College Savings Plans
Paying for the college education of a child or grandchild is one of the most common goals of families we serve. There are several ways to fund this effort, but one of the most popular is a Section 529 College Savings Plan.
529 plans are named for section 529 of the federal tax code but are sponsored by the states and operated by financial services companies. Pre-paid college tuition plans are also covered in section 529 and can be a good choice but are not as versatile as 529 savings plans, so this discussion will focus only on the 529 savings plans.
Money deposited into a 529 savings plan can be invested and if used properly, no taxes are payable on any of the earnings or withdrawals.
Money deposited into a 529 savings plan can be invested and if used properly, no taxes are payable on any of the earnings or withdrawals. “Used properly” means that the withdrawals are spent on certain “qualified” higher education expenses such as tuition, fees, room and board, books and supplies and a few other expenses incurred at a qualified university. Most schools you know are “qualified” meaning the institution is eligible to participate in a student aid program administered by the U.S. Department of Education. https://www.irs.gov/credits-deductions/individuals/earned-income-tax-credit/eligible-educational-inst In addition, the new tax law allows up to $10,000 per student per year to be used for some K-12 expenses including private school tuition.
This seems simple enough but there are some quirks. Recently we saw West Virginia on a list of the best 529 plans and on a list of the worst 529 plans. This contrast is not all that odd. Other states have found themselves on both the best and worst lists over the years. How is that possible?
One reason is because the lists are created by different entities and they may use somewhat different criteria in their evaluations. The real culprit, however, is because the lists are evaluating two different plans, as many states have more than one plan. Usually when this is the case, one plan is sold by brokers and the other is sold directly to consumers.
The plans sometimes have different investment options but the biggest difference between plans is usually the cost. Plans sold by brokers typically have higher costs to cover commissions paid to the sellers and their firms. The costlier, broker sold West Virginia plan is on the “worst” list while the direct purchase plan made the “best” list.
529 savings plans are unique and thus offer both opportunity and potential problems. Below are a few of the most prominent pros and cons of 529 savings plans.
Tax free withdrawals
A major benefit these plans have is the tax-free nature of withdrawals used for college expenses. This benefit is available to all taxpayers regardless of income.
The owner of the plan is usually a parent of the student named as beneficiary. The owner controls the account. Junior will not be able to empty the account to buy a sports car on the way to campus. Parental ownership is also better when it comes time to apply for financial aid because parental assets are treated differently than student assets.
You can use the savings plan of any state regardless of which state you live in or in which state the student attends college.
If the beneficiary does not attend college or use all the funds in the plan, the beneficiary can be changed to a family member of the beneficiary. There is no deadline as to when money in a 529 savings plan must be used. If there are funds remaining, it should be possible to avoid tax and penalties by continuing the plan and using the funds for a new beneficiary. This flexibility is important because not using the money for higher education results in high rates of tax.
Because “family member” is defined quite broadly, the potential for a 529 savings plan to be used for more than one student or even more than one generation is significant.
Flexible gifting plus gift/estate tax advantages
Anyone can open a 529 savings plan and the plan can accept contributions from anyone. This makes these plans handy for families who have multiple members wanting to contribute.
Those who wish to make larger contributions of $15,000 or more in a year can utilize the 529 plan’s unique 5-year gifting feature which allows up to $75,000 (5 years’ worth of gifts) to be made in one year without gift taxes. (For more, see How to avoid gift taxes).
Possible state income tax deduction
Contributions to 529 plans are made with after tax dollars so putting money in a plan won’t affect your current year taxes, unless you live in a state with state income tax. In that case, a deduction against state income tax (not federal income tax) is possible.
With no state income tax in Florida, most of our clients will see no benefit here.
Taxes and penalties
If you do withdraw earnings that are not used for qualified expenses at a qualified institution, the earnings are taxable plus a 10% penalty applies. To avoid this, you should keep records of exactly what was spent on college and be careful not to withdraw more than needed during the tax year.
Some states have “recapture” rules. If you take a state income tax deduction and subsequently transfer the funds to a better plan in a different state, the state in which the deduction was taken can reclaim those deductions.
Limited investment flexibility
In some ways, 529 plans resemble a typical 401(k) plan. You are limited to the investment options within the plan. In the better plans, these options are low cost and sufficient in number to build a good mix of investments.
However, unlike a 401(k) in which you can usually make changes whenever you like, the frequency of changes to the selections in a given 529 plan are limited. If an additional change is desired, you would need to move the funds to another state’s plan.
Prepaid college tuition plans are simple but not very flexible. Putting money into a regular savings account maximizes flexibility but offers no tax advantage. 529 savings plans by contrast offer both considerable flexibility and tax advantages. However, given the special rules regarding gifting, rollovers to family, financial aid, possible state income tax deduction quirks, and other items unique to 529 saving plans, there is plenty of potential for mistakes to be made.
Since we don’t work for anyone but our clients, we are free to recommend whatever college savings strategy is best. If a 529 savings plan is indicated, we will choose one from any state which best suits a given client. With proper planning, 529 plans can be a viable place to build funds to pay for college on a tax advantaged basis. With college costs so high, most families can use all the help they can get.
Moisand Fitzgerald Tamayo, LLC is an Orlando, Tampa and Melbourne, Florida based fee-only financial planner serving central Florida and clients across the country. Moisand Fitzgerald Tamayo, LLC specializes in providing objective financial planning, retirement planning, and investment management to help clients build, manage, grow, and protect their assets through all phases of one’s life and the many transitions in between. If you have any questions or would like to discuss anything further, please give us a call or send us a note. If you are not a client and wish to receive emails notifying you of new posts – no more than once per month – fill out the subscription information in the sidebar to the right. For more frequent updates, follow us on Facebook, LinkedIn, or Twitter.
Important Additional Information & Disclosures
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Moisand Fitzgerald Tamayo, LLC-“MFT”), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from MFT.
Please remember that if you are a MFT client, it remains your responsibility to advise MFT, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. MFT is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. Tax advice is given only to clients and only when agreed to by MFT. A copy of the MFT’s current written disclosure Brochure discussing our advisory services and fees is available for review upon request.
Please Note: MFT does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by any unaffiliated third party, whether linked to MFT’s web site or blog or incorporated herein, and takes no responsibility for any such content. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.
Please Note: Limitations: While MFT does NOT pay for recognition, awards, or publicity, neither rankings and/or recognition by unaffiliated rating services, publications, or other organizations, nor the achievement of any designation or certification, should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if MFT is engaged, or continues to be engaged, to provide investment advisory services. Rankings published by magazines, and others, generally base their selections exclusively on information prepared and/or submitted by the recognized adviser. Rankings are generally limited to participating advisers. No ranking or recognition should be construed as a current or past endorsement of MFT by any of its clients. ANY QUESTIONS: MFT’s Chief Compliance Officer remains available to address any questions regarding rankings and/or recognitions, including providing the criteria used for any reflected ranking.
Historical performance results for investment indices, benchmarks, and/or categories have been provided for general informational/comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your MFT account holdings correspond directly to any comparative indices or categories. Please Also Note: (1) performance results do not reflect the impact of taxes; (2) comparative benchmarks/indices may be more or less volatile than your MFT accounts; and, (3) a description of each comparative benchmark/index is available upon request.