UPDATED 01/01/2020: SECURE ACT (Setting Every Community Up for Retirement Enhancement)
What is a 529 plan?
Simply put, a 529 plan aka "Qualified Tuition Program" is a tax-deferred education savings investment vehicle designed to help individuals maximize education savings, primarily for college. The main reasons why 529s can be an efficient way to save is because of their tax-deferred nature (you don't pay taxes on earnings each year), and the fact that if used for qualified education expenses, the earnings in the account come out tax-free. The money you use to contribute to a 529 plan is always after-tax money (money on which taxes have already been paid). This means that when that contribute money is later withdrawn out of the plan for whatever reason, it is not taxed again. (Earnings may be taxed as we will discuss later.)
529 plans can be an extremely flexible and efficient way to potentially accumulate a significant amount of funds for education expenses. Why is this important? Education costs have risen, and continue to rise at about 2-3x the rate of inflation - the ability to have tax-deferred and tax-free earnings in an investment account help curb those high-rising costs. Setting aside money in other types of vehicles may not allow an individual to keep up with the rising costs.
As I mentioned previously, the interest/earnings in 529 plans (if used for qualified educational expenses) can be withdrawn from a 529 plan fed and state tax-free (except Alabama residents). Qualified educational expenses encompasses most expenses you'd expect such as: tuition, fees (except college app and testing fees), room and board (if enrolled at least half-time), books, laptops, printers, internet access, and educational/needed software to name a few. Unfortunately for some, transportation and beer are not included. To see the IRS guidelines on what is a qualified education expense, click here and see the section on QTPs or "Qualified Tuition Programs" (2018 figures).
Common misconceptions about 529 plans
- They are only for children and are for college expenses only.
529s are for anyone of any age! There are no age limitations for who can own or be the beneficiary of a 529 plan account. If you are an adult, you can fund a 529 for yourself to potentially use later in life to pursue a college degree, or even a Masters or Doctorate program. Since the Tax Cuts and Jobs Act of 2017, you can also actually use 529 funds for qualified K-12 expenses up to $10,000 per year, per beneficiary. This scenario typically won't be extremely beneficial unless you have a "legacy" 529 plan that already has significant funds in it for a beneficiary that young.
- They can only be used at large universities.
529 plans may be used at any college that is accredited by the U.S. Department of Education. This includes most post-secondary institutions in the U.S., even a lot of international institutions. They may even be used at community colleges, vocational schools, and trade schools (i.e. flight school, beauty school, etc.).
- The child or beneficiary for whom the funds will be for owns the 529 account.
529 plans can be owned by anyone; parent, grandparent, child, etc. However each can have their own implications, especially when it comes to qualifying for any sort of financial aid packages. The owner of a 529 plan directs how it is to be invested and designates the beneficiary of their choice. The beneficiary of a 529 plan is the individual to which the funds will be for. The beneficiary can be changed at any time, and to any family member of the current beneficiary (includes blood relatives and even by marriage or adoption).
This also means that the owner retains control of the account and at all times, the money is still theirs. They can take the money out for any reason, but will incur taxes and potentially a 10% penalty on any earnings in the account. This is opposed to an UGMA/UTMA account where the money in the account is the beneficiary's separate property to be received at age 18 or 21 depending on the account type and state laws. In the case of a 529, the owner generally has daily access, liquidity, and control.
- If the beneficiary doesn't use the money in the 529, it is a waste.
If the original beneficiary does not use or need the money because they don't further their education, you can change the beneficiary to another family member to use, it is not wasted. Not to mention, the owner can always go take the money out for themselves to use for whatever purpose they desire. This would be a non-qualified distribution subject to taxes and potential 10% penalty on the earnings only.
If worst comes to worst and a non-qualified distribution must be taken, some see this as at least being a form of "forced savings", even if they ended up paying taxes and a penalty. If the beneficiary receives a scholarship instead, the amount of the scholarship can be withdrawn from the plan without penalty. Bottom line, not all is lost.
- "I don't want to use a 529 because I want my child to qualify for needs-based financial aid".
This is a common misconception. 529 plans may be counted on FAFSA or CSS forms but it is not necessarily going to affect aid eligibility very much. It all depends on who owns the 529 and when, and the timing of withdrawals. If a parent or student owns the 529 plan, it will be considered an asset of the parent and would only affect aid eligibility by 5.64% (the benefits of a 529 could likely outweigh this).
However if a grandparent owns a 529 and takes withdrawals for the beneficiary, it is considered income of the student and can significantly affect aid - up to 50%. To curb this, grandparents can wait until the student's junior year to withdrawal funds (last time they file FAFSA/2-year lookback), or they can simply change the ownership to the parents (if the plan allows).
NOTE: Many people are surprised to find out that needs-based "financial aid" packages are mostly comprised of loans. This means that while many think they are getting aid, they are actually getting qualified for loans that they will eventually pay interest on which can INCREASE the cost of their education.
- I have to get the 529 plan specific to the state where the beneficiary is going to attend school.
Different 529 plans are offered by all 50 states, and anyone can get any of them for the most part (some can be exclusive to residents only). 529 funds are able to be used at any of the schools as noted above, no matter which state's plan you have - which is most. For example, you could have an Arizona sponsored plan, live in California, and use it for college costs in Boston, MA. The differences between each plan vary, but for the most part it has to do with certain tax benefits and the investments offered. Some states offer tax benefits for residents that get their own state's sponsored plan - check your state's plan to see if they offer a benefit. Some plan differences may also be that they allow owner changes and accept rollovers, vs. some that may not.
- Only the 529 plan account owner can fund the account.
The truth is, anyone can contribute to an individual's 529 account. Yes you read that right, your friend can write a check to your 529 account for your child's education. Contributions by any individual are treated as gifts given by that individual, therefore they may want to take the annual gift tax exclusion into consideration ($15,000 per year for 2019).
- Can you pay your student loans off with 529 funds tax-free?
We hear this a lot, and unfortunately I think there is a lot of bad advice out there on this. The answer is NO, at least for now. There is currently a bill in Congress to possibly address this. There are some advisors out there who might suggest you take student loans and keep your funds invested in your 529 plan throughout college (to get an extra few years of potential earnings), then take the funds and pay off your loans. I believe this is very bad advice, and it couldn't be more wrong. There are two principals that are "violated" here; one being that student loans are not a qualified expense, and two, you have to pay for qualified educational expenses in the same year the actual expense is incurred to get the favorable tax treatment.
SECURE Act Changes
The SECURE Act of 2020 allows you to take tax-free 529 plan distributions for repayment on student loans. Principal and interest payments toward a qualified education loan will be considered qualified 529 plan expenses. Please be aware that the portion of student loan interest that is paid for with tax-free 529 plan earnings - will not eligible for the student loan interest deduction. You do not need to itemize deductions to get this deduction, however it can phase out depending on your Modified Adjusted Gross Income.
The law includes an aggregate lifetime limit of $10,000 in qualified student loan repayments per 529 plan beneficiary, and $10,000 per each of the beneficiary's siblings. Siblings may include a brother, sister, stepbrother or stepsister. 1
Example: John is the beneficiary of a 529 plan (owned by his parents) with $70,000 in it. He uses his entire lifetime limit of $10,000 towards paying student loan debt, and never end up needing the remaining $60,000 in the plan. His parents then change the beneficiary to his younger brother. His younger brother has a separate $10,000 lifetime limit to use towards student loan repayment, if he eventually needs it.
How do 529 plans stack up against other forms of education savings strategies?
In our opinion, 529 plans may offer the best bang for your buck and flexibility when it comes to choosing an education savings vehicle. Some other account types that are frequently used are: UGMA/UTMA accounts, bank accounts, permanent life insurance policies, and Coverdell ESA accounts.
UTMA (Uniform Transfers to Minors Act) and UGMA (Uniform Gifts to Minors Act) accounts are custodial accounts. This means that the child owns them but an adult manages it, which also means that the money contributed is an irrevocable contribution to the child that can't be taken back. The earnings in these accounts are taxed under "kiddie tax" rules each year (not tax-deferred). Under the updated kiddie tax rules, once the account generates over a few thousand in earnings in a given year, they are now subject to trust tax rates which can reach up to 37% very quickly!
A child cannot take the funds in an UTMA or UGMA typically until age 18 or 21 depending on how it is set up and the state they are in, but they can use the money for whatever they want at that point. There's no guarantee the child will use this money for education...
Bank accounts like CDs or regular checking and savings accounts are known for their low interest rates. When you factor in the cost of college increasing at a rate of 2-3% per year, you can see why they may not work for your college savings plan. By earning less than 3% on average, you would not be keeping up with the increasing annual cost for college that the money is earmarked for.
Coverdell Education Savings Accounts (ESAs) have some of the same features as 529 plans, but with far more restrictions. Some major restrictions are that the maximum amount that can be contributed is capped at $2,000 per year and the account must be fully distributed by age 30. In a 529 plan there is no maximum amount per year, however there is a maximum account balance you can have before you can no longer contribute. For most plans as of 2019, that amount is $350,000 and up which isn't an issue for most people. One benefit advisors may like about Coverdell ESAs is that they can be self-directed. This might be useful if the owner wants to use physical real estate as the chosen investment, for example. But this can be very complicated and has quite a learning curve, so most would people wonder if it is even worth it to go down that road (usually not in my opinion).
Life insurance policies may be recommended by insurance agents out there that can only sell insurance, so they claim that their insurance policy is the right educational savings vehicle for you. They may be using permanent insurance as the "Swiss Army Knife" of financial planning because that is the only product they can offer you. The premise is that permanent life insurance policies can generate a cash value component that you can later borrow from tax-free to pay for education.*
Issue one, the policy has to actually accumulate a decent amount in cash-value. This is difficult because life insurance policies have a "cost of insurance" component in which you pay for - part of the problem itself, why pay for insurance when your goal is to pay for college? Usually to get a meaningful amount in cash-value you have to "overfund" a policy. Issue two, the policy has to stay in-force. This means that you need to make sure your premiums and any cash value left is adequate to cover the costs of the policy itself. If you lose your job or income, this can be problematic.
Contributions made to Roth IRAs can also be used but can cause issues if trying to get need-based financial aid. For financial aid purposes, withdrawals from Roth IRAs can be considered income to the student and affect the student's aid significantly. Not to mention, these accounts are designed for retirement as opposed to education, and the owner needs to have earned income to contribute.**
What if the funds in a 529 are not used for qualified educational expenses?
If for whatever reason the 529 funds are not going to be used for qualified educational expenses, you have a few options.
1. The owner can withdrawal the money and use it for whatever they please. Keep in mind there will be ordinary income taxes due on the earnings portion withdrawn and a 10 penalty on the earnings amount as well. There are some exceptions to the 10% withdrawal penalty like death, disability, and scholarships. The principal amounts withdrawn (what you put in) will always come back out tax-free. This is the worst case scenario but it's not so bad. In this situation, it essentially served as a forced savings account.
2. The owner can change the beneficiary to another family member of the current beneficiary.
3. The owner can do absolutely nothing and let the money sit in the account for the potential to continue growing tax-deferred. Then can decide much later what they want to do with it. You can keep 529s going for generations, even for those who aren't born yet! We call these "legacy" 529 plans.
Non-qualified withdrawals from 529 plans
Non-qualified withdrawals from 529 plans are distributed on a pro-rata basis. This is opposed to LIFO (last-in-first-out) and FIFO (first-in-first-out) methods. What pro-rata means is that a portion of each withdraw taken will be part return of principal and the other part earnings. Here's how to calculate the non-taxable amount of a non-qualified withdrawal:
You take the basis of the account, divided by the total account value, then multiplied by the amount withdrawn.
[ Basis (the total amount you put in the account) / Total Value of the Account ] x The Amount Withdrawn = Non-taxable Portion
The remaining amount of the total withdrawal is the earnings portion which would be subject to ordinary income taxation and a potential 10% penalty. The amounts withdrawn are also not subject to the Net Investment Income Tax or NIIT of 3.8%.
You have a 529 with a balance of $40,000 and wish to take a $4,000 non-qualified withdrawal and will be subject to the 10% penalty (assume 22% fed. tax bracket).
1. [ $25,000 (contributions/basis) / $40,000 (total account balance) ] = .625 x $4,000 = $2,500 (non-taxable return of principal)
2. $4,000 (total withdrawal) - $2,500 = $1,500 (earnings portion of withdrawal)
3. $1,500 x 22% = $330 in ordinary income taxes owed (this is only federal)
4. $1,500 x 10% = $150 in penalties owed
In this example you would owe a total of $480 in taxes and penalties.
Additional tips on 529 plans
- Anyone can gift up to 5-years worth of annual gift tax exclusions ($15,000 in 2019) without using any of their Unified Lifetime Credit (currently $11,400,000). Therefore a married couple can contribute up to $150,000 at once without tapping their credit ($15,000 x 5-years x 2 people). This can help relatives like grandparent remove a significant amount of assets from their estate if need be. In this case, the individual(s) making the gifts would file IRS form 709.
- Most plans allow you to rollover the funds from one plan to another (non-taxable event). It depends on the state, but this can be important for several potential reasons like investment choices or having the ability to change owners of the 529 plan.
- In order to be qualified, a distribution must be taken in the same year the actual expense was incurred for the qualified education expense you are wanting to pay for.
- You can't use the funds to pay for expenses you are otherwise trying to claim an education tax credit for such as the Lifetime Learning Credit or The American Opportunity Tax Credit. Consider using those first, then 529 funds for qualified expenses.
- Non-qualified withdrawals are taxable to the "payee" chosen at the time of withdrawal. This means that you can strategically instruct the plan custodian to make the check out to the beneficiary if they are in a lower tax bracket (or won't owe at all). The owner of the plan does not necessarily need to make the distribution to themselves - to then give to the beneficiary.
- Each school posts "cost of attendance" figures for financial aid purposes that outlines what it should cost. This is important if the student is going to live off-campus, as 529 qualified withdrawals for room and board will only count up to the amount the school posts. Example: School says off campus room and board is $1,600, but it actually costs the student $1,900, only $1,600 can be withdrawn from the plan tax-free as a qualified expense.
- Be careful not to overfund a 529 plan. We have literally seen this become a real problem with some clients (hard to believe there are people with way too much saved for college, I know). By overfund I mean, don't try to cap out your 529 at $500,000 or whatever the max is. Remember that not every little cost of education will actually qualify as a qualified expense, chances are there will be a lot left over that you ultimately will take out and pay taxes and penalties on. If your balances start getting a bit high, consider other savings vehicles! Even if you cap out at the max level, that only means you can no longer contribute, the account can still keep growing!
- For high income earners, the Net Investment Income Tax (aka 3.8% Medicare Surtax) does not apply to 529 withdrawals or earnings, EVER!
- Last but not least, get a good advisor that truly understands college savings strategies.
The bottom line
Having a good financial planner is key to a college savings plan. You can open a 529 plan on your own and plan for how you are going to pay for certain expenses, but it quickly becomes a daunting task. We run into this situation time and time again with clients who wanted to go it alone. There are many other factors than just investing when it comes to efficiently paying for education. Find a CERTIFIED FINANCIAL PLANNER™ practitioner and have them help guide you on your investments and plan out efficient ways to pay for college.
Cameron Valadez is a CFP® Practitioner.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer's official statement, which can be obtained from your financial professional. Be sure to read carefully before investing.
There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.
The information provided is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The strategies mentioned here may not be suitable for everyone. Each investor needs to review strategies for his or her own particular situation before making any financial or investment decisions.
Waddell & Reed does not provide legal or tax advice. Please consult a professional prior to making financial decisions.
*Income tax free distributions are achieved by withdrawing to the cost basis (premiums paid) then using policy loans. Loans and withdrawals may generate an income tax liability, reduce available cash value and reduce the death benefit or cause the policy to lapse.
**Roth IRA earnings withdrawn prior to the end of the Roth IRA five-year aging period and prior to reaching age 59½ will be subject to a 10% early withdrawal penalty unless used to meet qualified expenses.
***The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. This example does not represent any specific product, nor does it reflect sales charges or other expenses that may be required.