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529 Plan Insight: What are 529 plans and why are they important?

November 17, 2022 | By Kayla Sabbagh
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For many parents, funding higher education is one of the largest, if not the largest expense regarding their children. An unfortunate truth about college education is that it’s expensive and the cost is rising. According to a report from the Georgetown University Center of Education and workforce, the cost of tuition, room and board, and fees has increased 169% from 1980 to 2020.

With this rising cost, it is even more vital to be proactive about saving for higher education expenses. The good news is, there are investment vehicles that help investors save for these expenses in a tax-efficient way.

What is a 529 Plan?

529 plans are state-sponsored investment accounts that allow assets to accumulate and be withdrawn tax-free if used for qualified education expenses. Qualified expenses include tuition, books, technology, housing costs and additional fees. These costs can be applied to K-12 tuition up to $10,000, postsecondary education, an apprenticeship program, or the refinancing of existing student loans. Every state’s plan is different. You are not required to choose your own state’s plan, however many states offer a tax deduction/credit for contributions made by their residents.

Account Ownership

The account holder is the person who retains legal responsibility for and ownership of the funds in the account. A disadvantage of 529 plan ownership is that the assets are typically included in Expected Family Contribution (EFC) calculations. Your Expected Family Contribution is an index number that is used to calculate eligibility for federal financial aid. A lower EFC will mean eligibility
for larger amounts of federal student aid.

However, suppose that a grandparent instead of the parent is the account holder of a child’s 529 plan. In this case, the account’s value is not factored into financial aid calculations and has no bearing on Free Application for Federal Student Aid (FAFSA®) eligibility.

Additionally, custodian accounts such as a Uniform Transfer (or Gift) to Minors Account (UGMA/UTMA) funds are allowed to be transferred into a 529 plan as well. However, the UTMA will still be an asset of the child and be an addition to the Expected Family Contribution calculation for federal student aid considerations. The main advantage of this approach is that the UTMA assets will
be able to grow tax free if used for qualified education expenses. However, you will then lose the ability to use the UTMA/UGMA assets for non-education expenses without a potential tax penalty.

Apart from assets transferred in from a UTMA/UGMA account, which must remain for the benefit of that child, the account holder can change the designated beneficiaries on the 529 plan at any time. However, the new beneficiary must be a qualified relative of the original account holder. The IRS
defines qualified relatives as blood relatives and relatives by marriage and adoption. This flexibility allows for a change in beneficiary in the event the original child does not attend college and can then save the assets for another child or future grandchild. There is no time limit regarding when the
assets must be withdrawn.

Choosing a 529 Plan

Often, your state of residency will give a tax deduction for contributions to their plan. For example, contributing to New York State’s 529 plan qualifies for a maximum $5,000 annual state tax deduction ($10,000 if filing jointly).

Account holders of 529 plans can choose different investment portfolios constructed with a variety of risk preferences and time horizons. Your balance is subject to market fluctuations based on the plan’s investment allocations.

Before making any financial commitments, it is wise to evaluate your goals and the available options.

Tax deductibility, plan cost, and whether the plans are direct-sold or advisor-sold are all critical factors to consider when deciding on a plan.

Advisor-sold 529 Plans vs. Direct-sold 529 Plans

  • Direct-sold 529 plans are purchased from the state and usually have lower fees. This is an important consideration given that fees can have a large impact on performance over time. Investment choices for direct-sold 529 plans are typically limited and may only provide age or target-based asset allocation strategies. Direct-sold plans are generally easy for users to navigate.

  • Advisor-sold 529 plans are only accessible through financial advisors associated with registered investment advisors and broker–dealer firms. Unlike direct-sold plans, advisors may be able to create individualized investment portfolios or choose from a broader range of index funds. The advisor oversight and added customization associated with these plans usually come with higher fees.

An advisor may be incentivized to sell you an advisor-sold plan because the funds will be counted toward their assets under management (AUM) and are subsequently subject to their advisor fees. An advisor-sold plan may be the better choice, given the flexible investment choices and tailored portfolio approach. However, if an advisor is encouraging you to purchase their plan, make sure to ask for a thorough explanation for the reasoning behind the recommendation. Often, a direct-sold plan is cheaper, more user-friendly, and better suited to an investor’s needs. Wealthstream’s advisors are Fiduciaries and will assist with setting up and monitoring direct-sold plans, but they are
excluded from our management fees.

Insight: Learn More About Fiduciaries

529 Plans Contribution Rules

The maximum amount you can put away for a beneficiary varies from state to state but usually ranges between $230,000 and $550,000. However, you are still subject to the annual gift tax exclusion of $16,000 (as of 2022).

529 plans allow you to aggregate the 5 years’ worth of contributions into a single lump-sum deposit of up to $80,000 or $160,000 if you are married filing jointly, without using any of your lifetime gift/estate exemption.

By pooling your money, you can increase the compounding effect on your assets. Investing with a sizable initial sum can achieve a higher compounding rate.

However, a drawback of combining your contributions is that states will only allow a deduction in the year of contribution. If you contribute the entire $80,000 in year one to a New York state plan, you will only receive the $5,000 deduction for that year. Whereas contributing $16,000 annually over a 5-
year period, will allow you to take the $5,000 deduction each year.

Donating to a 529 plan creates an estate tax benefit. Contributions to 529 plans are considered completed gifts to the beneficiary and are kept separate from your taxable estate. The state will deduct the gift’s value from your estate while still allowing you to maintain control over the assets.

What Are the Distribution Rules for 529 Plans?

529 plans are designed to give investors tax free growth on investments if used to fund qualified education expenses. Higher education costs, tuition at accredited colleges and universities, and K–12 tuition up to $10,000 per year are eligible federal expenses. Some states, however, may not deem K-12 tuition expenses as qualified withdrawals.

Withdrawals for college can be used for things like room and board, books, and technology, in addition to tuition.

Non-qualified distributions from 529 plans come with repercussions. The distribution’s cost basis will be tax free, however the earnings will be subject to ordinary income tax and a 10% penalty. If your child were to receive a scholarship, you can take a distribution up to the scholarship amount without incurring the 10% penalty. The earnings on the distribution will still be subject to income taxation.

With a 529 plan, there are no mandatory withdrawal deadlines, and you are able to maintain the account indefinitely.

Bottom Line: Key Takeaways for 529 Plans

For their tax advantages and adaptability, 529 plans are a favorite among many households. Keep in mind these key points when deciding whether to participate in a 529 plan:

  • If the funds are used for qualified higher education costs, the growth and withdrawals from the plan are tax free.

  • Beneficiary titling can be changed at any time, so long as the new beneficiary designation is a qualified relative of the original.

  • Contributions to 529 plans are considered completed gifts, and grow outside of your taxable estate, while still allowing you to retain control over the assets.

529 plans are a great tool to help investors save for education expenses using a proactive and tax-efficient approach. If you are interested in taking the next step toward creating an education savings plan, schedule a complimentary 30-min consultation with one of our financial planners today!

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