States, Taxes and 529s March 27, 2015 Adviser Fund Update Print Which States Reward College Savers? A recent Adviser Fund Update focused on the basics of 529 plans. In this edition, we’ll continue examining 529s with a look at tax implications, riskThe probability that an investment will decline in value in the short term, along with the magnitude of that decline. Stocks are often considered riskier than bonds because they have a higher probability of losing money, and they tend to lose more than bonds when they do decline. strategies and the implications on financial aid eligibility. 529 Tax Implications Contributions to 529 plans are not tax deductible, though earnings made in the plans are not subject to federal taxes when used properly. Account owners can make annual gifts of up to $14,000 for single tax filers and $28,000 for those filing jointly to a beneficiary without exceeding the annual federal gift tax limit. 529s can work well as wealth transfer and estate planning vehicles. You can make a one-time contribution between $14,000 and $70,000 for a beneficiary and choose to treat the deposit as if it was made over a five-year period for gift tax purposes. For people whose financial professionals are advising them to reduce estate tax exposure, here’s a way to “gift” your assets without giving them up completely; revoke the account and its value comes back to your estate. Withdrawals also can have tax implications. Even if you know the exact amount of tuition you want to withdraw, make sure to subtract any grants or scholarships. As we discussed last time, taking out more money than you need for education-related expenses can lead to a paying federal income tax and a 10% penalty on the difference between qualified and non-qualified distributions. More than 30 states and the District of Columbia currently offer a tax credit or deduction on 529 plans. If you live in one of these states, there could be a strong incentive to invest at home. Arizona, Kansas, Maine, Missouri, Montana and Pennsylvania offer tax parity, meaning you can invest in any state’s plan and get that state’s tax benefits. Tax Parity States State Maximum Annual 529 Deduction Arizona $2,000 single or head of household/$4,000 joint Kansas $3,000 single/$6,000 joint per beneficiary Maine Up to $250 per beneficiary (any state plan) for contributors with adjusted gross income of $100,000 or less if single filer or $200,000 or less if filing jointly Missouri $8,000 single/$16,000 joint per beneficiary Montana $3,000 single/$6,000 joint per beneficiary Pennsylvania $14,000 single/$28,000 joint per beneficiary Source: J.P. Morgan Asset Management. State Tax Deductions State Maximum Annual 529 Deduction Alabama $5,000 single/$10,000 joint Arkansas $5,000 single/$10,000 joint Colorado Full contribution amount up to contributor’s adjusted gross income Connecticut $5,000 single/$10,000 joint, five-year carry forward of excess contributions District of Columbia $4,000 single/$8,000 joint, five-year carry forward of excess contributions Georgia $2,000 per beneficiary per tax return Idaho $4,000 single/$8,000 joint Illinois $10,000 single/$20,000 joint Indiana 20% tax credit on contributions up to $5,000 Iowa $3,098 single/$6,196 joint per beneficiary (adjusted annually for inflation) Louisiana $2,400 single/$4,800 joint per beneficiary, unlimited carry forward of excess contributions Maryland $2,500 per beneficiary per year, 10-year carry forward of excess contributions Michigan $5,000 single/$10,000 joint Mississippi $10,000 single/$20,000 joint Nebraska $10,000 per tax return; $5,000 if married filing separately New Mexico Full amount of contribution New York $5,000 single/$10,000 joint North Dakota $5,000 single/$10,000 joint Ohio $2,000 per beneficiary, unlimited carry forward of excess contributions Oklahoma $10,000 single/$20,000 joint, five-year carry forward of excess contributions Oregon $2,225 single/$4,455 joint, four-year carry forward of excess contributions Rhode Island $500 single/$1,000 joint, unlimited carry forward of excess contributions South Carolina Full amount of contribution Utah 5% tax credit on contributions up to $1,860 per beneficiary for single filers or $3,720 per beneficiary for joint filers (maximum credit $93/$186) Vermont 10% tax credit on up to $2,500 in contributions single/$5,000 joint (maximum credit $250/$500) Virginia $4,000 per account per year (fully deductible age 70 and older), unlimited carry forward of excess contributions West Virginia Full amount of contribution Wisconsin $3,000 per dependent beneficiary, self or grandchild; $1,500 if married filing separately Source: J.P. Morgan Asset Management. No State-Specific Benefits No State Tax Deduction No State Income Tax California Alaska Delaware Florida Hawaii Nevada Kentucky South Dakota Massachusetts Texas Minnesota Washington New Hampshire Wyoming New Jersey North Carolina Tennessee Source: J.P. Morgan Asset Management. Managing Your 529 Plan As many investors scale back their equityThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid. allocation and opt for more fixed-income investments on the approach to and beginning of retirement, a similar strategy can make sense with 529s. By starting early, it may make sense to weight the 529’s investments more towards equitiesThe amount of money that would be returned to shareholders if a company’s assets were sold off and all its debt repaid., which generally have better long-term growth potential than bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. or cash. Once college expenses come closer, you might feel that fixed income is more appropriate to protect your earnings and make sure that you are insulated against market declines now that you actually need the money. Under current tax law, you can reallocate your account once a year. (Speaking of retirement, parents need to consider their own priorities if weighing the decision to only fund their own retirement portfolio or a child’s 529 fund. After all, your child can always borrow money for college. You can’t borrow money for retirement.) Other college savers can opt for age-based 529 plans to avoid the legwork of shifting allocations. Vanguard, for example, offers a questionnaire for parents to determine their risk toleranceThe amount of loss an investor is willing to absorb in their investment portfolio.. Once set on a conservative, moderate or aggressive course, Vanguard will automatically adjust asset allocation over time, gradually shifting from stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. to bonds as college age approaches. Many other plans share similar risk or age-based tracks for more hands-off investors. Financial Aid Implications The College Cost Reduction and Access Act of 2007 (CCRAA) enacted legislation to treat assets held in 529 prepaid tuition plans and college savings plans as parental assets (rather than as belonging to the student), and thus generally have little impact on a student’s federal financial aid eligibility. Savings in 529 funds are reported on the student’s Free Application for Financial Aid (FAFSA) as parental assets, which are currently assessed at 5.64%. For example, under the CCRAA, if a student’s parents have $25,000 in a 529 plan, only $1,410 will be considered the student’s “Expected Family Contribution.” Let’s walk through an example, assuming you file the FAFSA aid application when your child is a high school senior. You have a 529 account with $100,000 in it, of which $50,000 was your initial contribution and $50,000 is earnings. In the first year, your child’s eligibility for federal financial aid will decrease by no more than 5.64% of the account value, or $5,640. Assuming the account value stays the same over the course of the year and you withdraw $20,000 to pay for freshman year education expenses, when you apply for sophomore year aid, your account value is now $80,000, which is again assessed at 5.64%, or $4,512. The $20,000 withdrawal included $10,000 of excluded earnings with it, but none of the withdrawal is counted as financial aid income. There is a widespread misunderstanding, even on the websites of many plan administrators, of the impact of a grandparent’s 529 plan on a student’s eligibility for need-based financial aid. True, the value of 529 plan assets owned by a grandparent (or any non-parent) is not reportable on the FAFSA application. However, precisely because grandparent-owned 529s do not have to be reported as an asset on FAFSA applications, any distributions from those 529s are considered untaxed student income on the next year’s FAFSA. Any financial support given to a student from their grandparents, even 529 distributions, counts as untaxed income and is reportable on the next year’s FAFSA as student income. There are ways to circumvent this. The savvy grandparent might wait to use the 529 account to pay for senior year of college, when the student will not need to worry about applying for financial aid again. Grandparents can also transfer the account to a parent, so the 529 counts as parental assets, as seen above. Finally, grandparents can wait until the student has graduated and take a non-qualified distribution (perhaps to pay off student loans). While you’ll pay income taxes and a penalty on the earnings of non-qualified distributions, those hits can be less than losing eligibility as a result of untaxed income going to the student via 529 distributions. Notable 529 Plans In an upcoming Adviser Fund Update, we’ll conclude our series on 529s with an in-depth look under the hood of several popular plans, including the Maryland College Investment Plan, T. Rowe Price College Savings Plan, The Vanguard 529 and the Utah Educational Plan. We’ll also give our take on Fidelity’s 529 plan options. Further Reading Smart Ways to Save (and Pay) for Education Review of Vanguard 529 Plans About Adviser Investments Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trusts, institutions and foundations since 1994, and have more than 3,500 clients across the country and over $6 billion in assets under management. Our portfolios encompass actively managed funds, ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). 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