By: Raquel Tennant, CFP®
As the holiday season kicks off in earnest, our minds have turned to preparing for supply chain delays and finding the best deals on children’s toys and gifts. Eliminate the long Black Friday lines and shipping days; consider giving your children or loved ones the gift that keeps on giving, a funded college education.
Investing in a 529 plan can help you save for a child’s college and includes a number of benefits that regular savings accounts do not have. You can reduce anxiety that comes with preparing for this big transition in your family’s life and finances.
If you are giving to a child this holiday season, here are eight important facts you should know about 529 plans:
1. Earnings Grow Tax Free
When you invest in a 529, the earnings from your investments accumulate tax free. It is also untaxed when the money is taken out and used for qualified expenses.
2. Used for More Than College
Funds used can be used for various types of education, including trade, vocational, graduate and technical school. Up to $10,000 per year can be used towards education costs from grades K-12 in private, public, and religious schools.
3. Rules for Using the Funds
Withdrawals are made by check or electronically to the owner, beneficiary or institution. You will be issued Form 1099-Q, but if funds were used for qualified expenses there is nothing to report on your tax return. The Form 1099-Q, however, does not report whether the distribution is Qualified or Non-Qualified. The account holder is responsible for retaining records to support the type of distribution that was taken.
4. Types of Qualified Expenses
Tuition, room & board, fees, books, and apartment rentals while in school are considered qualified expenses. However, qualified apartment rent costs can’t exceed on/off campus housing costs published by the school. Expenses for study abroad are also qualified if the student is enrolled as at least a half-time.
Note: Airfare for study abroad does not qualify.
5. Options for Unused Funds
If the 529 beneficiary decides not to pursue secondary education, or has leftover funds after graduation, there are alternatives. For example, the owner may transfer the account to a new beneficiary tax free if the new beneficiary is a family member of the old beneficiary.
6. Ownership Flexibility
In addition to beneficiary changes, 529’s also allows changes to ownership. For example, a grandparent or relative can transfer ownership of the account to the parent for the benefit of the same child. Most 529’s also allow a named contingent beneficiary in the event of an untimely death or health event.
7. Tax Cost of Nonqualified Withdrawals
If there are no suitable beneficiaries or remaining qualified expenses to use the 529 balance, you can withdraw the principal contributions and earnings outright. The earnings portion of the nonqualified withdrawal will be subject to ordinary income tax plus a 10% penalty. The principal contribution(s) will not be subject to income tax or penalty.
These circumstances avoid the 10% penalty but are still subject to income taxes are:
Beneficiary becomes disabled or dies. You can withdraw the full 529 value.
Beneficiary attends a U.S. Military Academy. You can withdraw the full 529 value.
Beneficiary receives a scholarship. You can withdraw up to the amount of the award.
When receiving scholarships, first use funds for qualified expenses that scholarships may not cover, like room & board, housing costs for off campus living, textbooks, laptops/computer, etc. Then withdraw up to the amount of the scholarship without penalty.
8. Advantages over Custodial Accounts
Custodial accounts such as Uniform Transfers to Minors (UTMAs) or Uniform Gifts to Minors (UGMAs) give less control and flexibility to the account owner. Once a custodial account is created, neither the owner nor beneficiary can be changed.
If the owner dies before the beneficiary reaches age of majority, the full value is included in their taxable estate. A 529 is not included in the decedent’s estate and can be transferred to the contingent owner.
Moreover, once the beneficiary reaches the age of majority, typically at 18 or 21 depending upon state law, the owner no longer has control of the account. The beneficiary can spend the money freely. With 529’s, the account owner is in control regardless of beneficiary age. The fund use is also limited to education related expenses, unless electing withdrawal with penalty and taxes.
While 529 account earnings grow tax deferred, custodial accounts do just the opposite. Any earnings from an UTMA/UGMA over $2,200 are subject to “kiddie tax”. Kiddie tax uses the tax rates of Trusts and Estates, which are significantly higher than ordinary income tax rates.
Lastly, when applying for Financial Aid, an UTMA is considered the child’s assets. Twenty percent of assets owned by the child are expected to be used to pay for school. In contrast, a 529 is considered the parent’s assets. Colleges expect just 5.64% of “unprotected” parent assets to be used for school. Examples of protected assets include net worth of the family home, retirement plan accounts, and life insurance policies, which are non-reportable to FAFSA.
Embrace the Power of this Unique Gift
Give the gift of investing in a child's future this holiday by contributing to 529 Plan. Remember to consider its flexibility, purpose and tax implications. 529’s can be very helpful in paying for education expenses while providing the opportunity to benefit more than one child if needed, provided you understand the rules.