In September, we covered the basics of 529 plans. This week, 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 how they can impact financial aid eligibility.
529 Tax Implications
Contributions to 529 plans are not tax deductible (at the federal level, treatment varies at the state level), though earnings made in the plans are not subject to income taxes when used properly. Account owners can make annual gifts of up to $15,000 for single tax filers and $30,000 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 of up to $75,000 ($150,000 if married filing jointly) 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, this is a way to “gift” your assets without giving them up completely; change the account’s beneficiary back to yourself and its value comes back to your estate (with some strings attached for non-qualified distributions, however).
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. And taking out more money than you need for education-related expenses can lead to paying federal income tax and a 10% penalty on the difference between qualified and non-qualified distributions.
Currently, 29 states and the District of Columbia offer a tax credit or deduction for contributions to their state’s 529 plans. If you live in one of these states, there could be a strong incentive to invest at home (see second table below for tax-year 2019 deductions). Arizona, Arkansas, Kansas, Minnesota, 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 Tax Deductions (for contributions to in-state plans)
No State-Specific Benefits
Managing Your 529 Plan
The “glide path” approach is a popular one in 529 plans. Just as many investors scale back their stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. allocation and opt for more bondA 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. investments on the approach to and beginning of retirement, the strategy can be applied by college savers in 529s.
The idea is to direct the 529’s investments more toward stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company., 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, when the beneficiary is young. Once college expenses come closer, you might feel that bonds or cash are 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 twice a year, and you can change how future contributions are allocated as often as you like.
(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 the asset allocation over time, gradually shifting from stocks 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 includes $10,000 of excluded earnings with it, but none of the withdrawal is counted as financial aid income.
There are a few things to be aware of if you’re a grandparent of or not the legal guardian of your chosen beneficiary when it comes to financial aid. True, the value of 529 plan assets owned by a grandparent (or any non-guardian) 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 a future 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 FAFSA as student income.
However, under new rules announced in late 2015 that went into effect for the 2017–2018 academic year, 529 plan distributions are reported as student income two years after those funds were used for qualified expenses. The student’s FAFSA for her senior year will reflect the income received when she was a sophomore under the new rules, rather than that from her junior year.
So, the savvy grandparent might wait to use the 529 account to pay for junior and senior years of college, when the student will not need to worry about applying for financial aid again (unless they plan to receive aid for graduate school within the next two years). 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 costly 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 Virginia529 INVEST, T. Rowe Price College Savings Plan, Vanguard 529 College Savings Plan and the Utah Educational Plan. We’ll also give our take on Fidelity’s 529 plan options.
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