Saving for your children’s education can be a daunting task. This is particularly true today more than ever in light of the unprecedented and relentless rise in the cost of higher education. For many parents, whether natural or adopted, great, grand, or god (and even many benevolent aunts and uncles), planning for the future educational needs of a young person is a recurring line item on a “list of priorities” to be addressed by a comprehensive estate and financial plan.
Of course, there is more than one way to skin the cat of higher education, and conscientious investors have many different investment vehicles available to assist them in saving for college. The focus of this article is one particular type of plan: the 529 Savings Plan, referred to in Section 529 of the Internal Revenue Code as a “Qualified Tuition Program.” In Virginia, 529s have recently come to be associated with the taming of the big green Tuition Monster on cringeworthy local TV commercials.
Unfortunately, the popularity of the Tuition Monster has not been accompanied by a proportionate increase in understanding of the capabilities of 529 Plans. Hopefully after reading this article, you will have a better idea of whether a 529 Plan could be a good investment tool for you, and how to ensure that the right people can handle and manage the Plan in your absence.
What is a 529 Plan?
529 Plans are a lot like the Generation Z recipients that they contemplate: woefully misunderstood.
In a nutshell, 529 Plans are tax advantageous plans operated by the individual states or particular educational institutions that enable participants to save money for “qualified higher education expenses.” These expenses include tuition and fees, books, room and board, computers and other technology-related equipment, and special needs equipment. As of 2018, the term “qualified higher education expenses” also includes up to $10,000 per Beneficiary per year in expenses related to the Beneficiary’s enrollment at a K-12 public, private, or parochial school. Yes, you read that correctly: you can now use funds from a 529 plan to pay for your child’s K-12 tuition. Whether or not doing so makes sense is another matter altogether.
Who are the Players in a 529 Plan, and What do they Do?
There are three important roles to think about when setting up a 529 plan:
- the plan’s OWNER, who is the individual setting up the plan, who will be making contributions to it (although other individuals who are not Owners may also make contributions to an established plan);
- the plan’s BENEFICIARY, who is the student for whom the Owner intends to provide; and
- the plan’s DESIGNATED SURVIVOR, who is the person named to manage the plan in the event that the Owner is not able to do so.
One of the key features of 529 Plans as opposed to other college-savings methods is that the Owner retains control of the account, rather than the Beneficiary, regardless of the Beneficiary’s age. This is an important distinction that is sometimes glossed over: when you open a savings account in your intended Beneficiary’s name, or a joint account with your intended Beneficiary, or even a custodial account under the Uniform Gifts/Transfers to Minors Act(s), your Beneficiary will have legal rights to the funds in the account when he reaches 18 or 21 years of age. Theoretically, your 18-year-old Beneficiary could take that money, buy a plane ticket to Vegas, and blow it all in one weekend if he was inclined to do so. 529 Plans do not create these legal rights in the Beneficiary. If circumstances change in the Owner’s life and there is a need to pull those funds back out to address an emergency, the Owner can do so. Thus, 529 Plans help achieve another common estate planning objective: keeping the planner in control of his finances for as long as possible.
What are the Specific Tax Advantages of 529 Plans?
The central tax advantage of 529 plans is that the investment’s earnings are generally never taxed federally, so long as the funds are eventually used for qualified expenses. (I use the word “generally” because we’re dealing with the IRS, and so there is, of course, a possible scenario where the Beneficiary may pay some minimal tax on the investment’s earnings. However, this possibility is remote, so I will not discuss it in detail in this article).
In the Commonwealth of Virginia, contributions to a state-sponsored 529 Plan are also deductible on your state tax return, and distributions for qualified expenses are exempt from state income taxes. This means that funds which are placed in a Virginia-specific 529 Plan and later used for qualified expenses will grow tax-free, and the earnings will never be taxed at either the state or federal levels, and you’ll get a break on your Virginia tax return when you make contributions to a Virginia 529 Plan.
Funds that are withdrawn for non-qualified expenses will be subject to a 10% penalty on the earnings portion only, which will also be subject to regular state and/or federal income tax. Contributions (or “return of the investment”) will never be subject to additional taxes or penalties because they are paid with post-tax dollars.
For example, let’s say that Grandmother Beatrice opened a 529 Plan for her favorite grandson, Chad, and funded the Plan with a one-time contribution of $500 non-qualified (post-tax) dollars. Beatrice then let that amount grow tax-free for fifteen years, until Chad reached age 18 and was ready to head off to college. By this time, let’s suppose that Beatrice’s investment has grown to $600. If Chad uses those dollars for qualified expenses, such as tuition and books, neither he nor Beatrice will ever pay state or federal taxes on the $100 of growth experienced in the account.
However, if we change the scenario to say that Beatrice needs to tap into those funds to do some repairs to her car when Chad is only ten years old (sorry, Chad!), and the account has grown to $530 by that time, Beatrice will pay federal and state income taxes and a 10% penalty on the amount of growth only (in this situation, she will pay a $3 penalty on the $30 increase). The Commonwealth of Virginia may also make a claim for recapture of any tax deductions she had previously taken related to the 529 Plan contributions. The contribution portion (the $500 start-up money), however, will not be subject either to taxes or penalty.
In this example, Beatrice’s choice to invest in a 529 Plan turned out to be a relatively low-risk investment for a few reasons. First, it enabled her to retain control of her funds because she never gave up ownership of those dollars. This was important in light of the unexpected car troubles she experienced. Second, if she then wanted to pull out the funds and use them for non-qualified expenses, the potential penalty she faced was relatively minimal. Third, as we will see later, if Chad finds another way to pay for his college, Beatrice can change the Beneficiary on the account to another family member without incurring any tax liability or penalty. The IRS’s definition of “family members” in this context is broad enough to encompass Chad’s siblings, parents, first cousins, in-laws, and even any of their spouses.
However, it is important to note that 529 Plans are investment vehicles. They are more akin to your 401k than your saving account at the bank. In fact, the investment options for 529s may look remarkably similar to those offered within your 401k: you can select an investment option that corresponds to your Beneficiary’s anticipated graduation date, much like you can select a 401k investment option that corresponds to your anticipated retirement date. However, because 529s are investment vehicles, your contributions will be subject to and affected by the market’s performance. So, while a young family could, for example, funnel costs of private K-12 tuition through a Virginia 529 Plan in order to take advantage of the state tax deductions and hope for some quick growth in the account, the administrative costs of the plan may make this prohibitive. Like many other investment vehicles, 529 Plans are intended to allow for tax-free growth over a period of time.
What Different Types of 529 Plans are Available?
As mentioned above, 529 Plans come in two different flavors: (1) prepaid tuition plans, in which a participant “locks in” the price of tuition and pays for a future college education in current dollars and cents; and (2) savings plans, which enable a family to save funds in a tax-advantageous way in order to pay for not-yet-quantified future costs of higher education.
And as you may expect, all 529 Plans are different. If you want to invest in one, be sure to take a look at the different investment options, any restrictions on in-state use, the history of performance, and the administrative costs associated with the plan.
What are the Unique Features of 529 Plans and Why do People Prefer Them?
When compared with other investment options, 529 Plans are uncharacteristically flexible. Unlike Roth IRAs or Coverdell Education Savings Accounts (ESAs), there are no income restrictions placed on 529 Owners or contributors. So, regardless of how much or how little you make, you can contribute to a 529 Plan. Additionally, there are no annual contribution limits for 529 Plans—other than the annual gift tax exclusion, which is currently $15,000 per individual, or $30,000 for a married couple. In fact, the only limit on contributions is that they cannot exceed the amount necessary to provide for the qualified education expenses of the Beneficiary (which can be as high as half a million dollars per Beneficiary).
Just when you thought perhaps you should re-read that last bit, consider this: certain 529 Plans include an option which allows you to treat a contribution of up to $75,000 in one year as if it had been made over a five-year period, in order to shelter a large amount from taxes.
Additionally, account Owners can roll over any unused funds into a 529 Plan for another member of the family without incurring any additional tax liability or penalty.
Finally, there are no age limitations by which the funds must be spent—at least, none that cannot be easily avoided.
So if you have a surplus because Junior turned out to be a genius (the apple doesn’t fall far from the tree), you can roll the funds over to an account for Junior’s sibling. Or you can continue to save the funds for Junior’s post-graduate education, or even save for Junior’s kids. You may even use the funds to go back to school yourself—everyone else is doing it. In each of these scenarios, you would not incur any additional tax liability or penalty for retaining those funds in the 529 Plan and channeling it towards a family member.
A good Rule of Thumb for saving with 529 Plans is: determine the amount that you want to invest and then look for a family member to shovel the funds onto as life unfolds.
How do I Ensure my 529 Plan will Cooperate with my Overall Estate Plan?
Owners tend to only be thinking about the Beneficiary when they establish a 529 Plan, but it is important to consider who would be appropriate to name as the Designated Survivor in the event of the Owner’s incapacity or death. Candidates for this role often include:
- the Beneficiary’s parent(s);
- the Beneficiary herself, provided she is at least 18 years old;
- the Owner’s Agent under her Power of Attorney.
Obviously, this is an estate planning decision that should be made with the advice of your estate planning attorney. The individual circumstances of each situation must be considered, along with the financial maturity of the Beneficiary (or her parents), family dynamics and diplomacy, the existence of other potential Beneficiaries, and the relative size of the account.
One option available if you are planning with a Revocable Living Trust is to name the Revocable Trust as the Designated Survivor of the 529 Plans. This enables you to control the account during your life, but upon death the then-serving Trustee will have the authority to manage the 529 Plan and make distributions for the benefit of the Beneficiary. This also incorporates all your contingency planning into the 529 Plan itself, which is particularly helpful because it allows you to name a deep bench of possible successors, rather than limiting the Owner to only one option.
Additionally, to account for possible incapacity, you should ensure that your General Durable Power of Attorney is drafted so as to give your Agent the ability to handle and manage the 529 Plans. This includes, but is not limited to, making distributions from the account, making elections regarding the investment of funds, and naming a different Beneficiary.
Planning for the succession of your 529 Plan on these two different fronts helps ensure that the control you retain by planning for college with 529 Plans will end up in the right hands, so that the funds will be used for the advancement of your intended Beneficiary, and in a way that maximizes the tax advantages that these wonderful plans have to offer.