A CPA breaks down a tax-smart way he saves for his children’s education expenses
My favorite college savings tax planning opportunity is a 529 plan. As a father, saving for all my four kids’ college costs is one of my dreams. Unless I want it to be a pipe dream, I believe that I need to set goals to help accomplish this dream. Everyone knows that when you set a goal it is important for you to track your progress. When I have financial goals, I like to have a separate or dedicated account or asset that I can track as I work towards my goal.
As a tax planner, I especially appreciate when the tax code gives me a tax-advantaged vehicle to serve as this dedicated account. Just as an Individual Retirement Account (IRA) provides tax benefits for retirement savings, 529 plans can be a tax-smart way to save for a child’s education.
The Basics of 529 Plans
529 plans are a tax-advantaged way to save and invest for future educational expenses for your family. Contributions do not get invested on a pre-tax basis like an IRA, but there are other tax aspects that are specific to educational goals that 529 plans are uniquely designed to address. 529 plans are not the right tool for everyone. However, over the years I have shared the advantages of 529 plans with many clients and I personally have funded 529 plans to meet my family’s educational goals.
Accountants are not usually known as very creative types, and so the 529 plan simply takes its name from Section 529 of the Internal Revenue Code. The section authorizes each state to offer 529 plans as a way for taxpayers to save for future education expenses. Each state’s plan may be slightly different, but they have many of the same characteristics.
There are three main actors for each account under a plan.
- The grantor, who makes contributions to the account. Often the grantor is also the owner of the account, but not always.
- The beneficiary of the account, who will ultimately receive the invested funds as a distribution, either directly or indirectly, to cover college and other education expenses.
- The owner of the account, typically the parent or grandparent of the beneficiary. Now, the owner of the account does not actually own the assets in a 529 plan from an estate planning perspective – contributions into the account are considered completed gifts to the beneficiary at the time of funding. However, the owner manages the investments and controls the account.
Contributions to a 529 plan account do not qualify for a federal income tax deduction. However, many states offer a state income tax deduction to residents of their states who make contributions to that state’s 529 plan. Usually, the deduction is available to the person making the contribution, but sometimes the deduction is only available to the owner, even if that person is different than the grantor.
For example, if a grandparent contributes to a 529 plan that the parent set up for the grandchild, the parent may receive the state income tax deduction in some states. This deduction is usually capped at a specific dollar amount, either per account, per beneficiary, or per taxpayer. Each state is different so you will need to look at the rules of your specific state.
As an example, in Virginia there is a $4,000 deduction available for every 529 plan account. So, if my wife and I are both owners of separate 529 plans for our four kids, that is a total of eight accounts. If we funded each one with $4,000, we would be eligible for a $32,000 deduction in the year we contribute. Any excess funding is typically carried forward to be deducted in a future year. Some states have higher (or no) limits on the deduction for contributors over certain ages. This can allow grandparents to be able to gift more of today’s dollars into a 529 plan.
The funds that are invested in a 529 plan then grow tax-exempt during the years they stay in the plan. The annual earnings, interest, dividends, and capital gains distributions are not taxable income. The available investments vary by state, but are typically mutual funds, exchange-traded funds (ETFs), or some type of target-based fund. Some states even have pre-paid tuition plans where the contributions are not invested but are instead a pre-payment of a year’s worth of tuition in the future at today’s rate.
The return on the investment for those plans is the amount that college tuition increases between today and when the child attends college. You can research the performance of the funds in the various state plans to determine which best suits your needs. However, picking a plan in your resident state is usually the most advantageous if you are eligible for an income tax deduction on your state return.
Permissible Uses of 529 Funds
When it is time for the beneficiary to use the funds from the account to pay for their educational expenses, the earnings and the principal both come out tax-exempt. So, the 529 plan is not a tax-deferred, but rather a tax-exempt account, so long as funds are used for qualifying educational expenses.
There is a broad definition of qualifying educational expenses that includes tuition, educational materials, room, board, and fees required for higher education (college, university, etc.). Funds can also be used towards expenses for advanced degrees such as a master’s degree or a doctoral degree.
Several years ago, the tax code was changed to allow up to $10,000 to be used for K-12 expenses for each beneficiary each year. This additional distribution won’t help everyone, since it means there is less time for tax-exempt growth, but it may allow you to take additional state income tax deductions (or free up cash flow) by using savings from 529 plans that may be overfunded.
If the distribution is for a disqualifying purpose, then the pro-rata earnings on the distribution are taxed as ordinary income, in addition to a 10% penalty. There is a limited exception where it could be beneficial to elect to have a portion of the earnings be taxable (but not subject to a penalty) in the year of the distribution if it allows you to take an educational credit, such as the American Opportunity Tax Credit, on the tuition that was paid from the 529 plan.
Any tax planning strategy needs to include some amount of flexibility because it is impossible to know the future. 529 plans have a lot of flexibility, which is one of the reasons that I like them. The account owner may transfer ownership to another individual at any time. There are no gift or income tax implications from this change. Within certain restrictions, you may also change the beneficiary without any income or gift tax implications. Generally, picking other family members as beneficiaries would avoid gift tax issues.
There are several reasons why you might change the beneficiary. If one sibling has higher expenses than other siblings, if the spouse of the beneficiary doesn’t have college savings, or if the beneficiary has finished their education and would like to transfer the remaining balance to the next generation, it can allow the original gifts to keep on giving. There is also flexibility with where you use the funds. Just because I have a Virginia 529 plan doesn’t mean that my children must attend school in Virginia if they don’t want to.
A contribution to a 529 plan is considered a current completed gift for gift tax purposes, even though the funds may not be used for many years. If the gift to each beneficiary is less than the annual gift exclusion, then there are no gift tax implications. You can also elect gift splitting with your spouse to give twice the annual gift exclusion amount.
Also, there is a special provision in Section 529 that allows you to make a gift of up to five times the annual gift exclusion in one year, and then elect to spread that out over the next five years for gift tax purposes. So, if I were to prefund my child’s 529 plan with $75,000 today, I could make this election when I file a 2021 gift tax return. I would use up the next five years of gift tax exclusions from me to that child, but I would not use up any of my lifetime exemption. This is a special provision only available for 529 plan funding.
However, 529 accounts are not for everyone. 529 plans can impact need-based assessments from colleges. Also, for gift tax purposes, it may be more beneficial for grandparents to use the educational exclusion for schooling and use the annual gift exclusion for other family gifts instead of funding a 529 plan.
I hope that I have shared some ways that a 529 plan could work for your family to help you reach your educational and gifting goals in a tax-smart way. At Creative Planning, education planning is an important part of our comprehensive process, and a wealth manager can help you determine how much, and how, to save for a child’s education. If you have questions about 529 plans, or any other financial matter, please contact us.