By Brittany Goodwillie, CFP®
One of the most important goals a parent has is saving for his or her child's college education. Though there are several vehicles for college savings, the tax benefits of 529 plans make them a tool every parent should consider. Before investing in a 529 plan, it may be helpful to know a few key things.
1.) Funds in a 529 plan grow tax-free and will not be taxed when withdrawn.
The earnings from the funds you invest in a 529 plan are not subject to federal tax and are generally not subject to state tax when withdrawn for qualified education expenses of the designated beneficiary.
In some states, you can also receive a state tax deduction for your contribution. In Michigan, contributions of $10,000 by a married couple filing jointly ($5,000 for an individual) made by December 31st are deductible in computing taxable income.
2.) 529 funds can be used for several expenses ...not just tuition.
As long as 529 funds are used for qualified higher education expenses, they aren't taxed or penalized. What is classified as a qualified expense? Tuition and fees, room and board, textbooks, supplies, and even computers are considered qualified expenses. So yes, 529 funds can be used for groceries so your college child can eat more than just pizza and pop-tarts.
But be careful, if you use 529 funds for non-qualified expenses, you will face repercussions. Not only will you need to pay tax on the earnings, but you will also pay a 10% federal penalty on all earnings and be required to repay any state tax deductions you previously claimed. Non-qualified expenses include entertainment (such as dining out), transportation, repaying loans, insurance, and sports or activity fees. There is also a limit on the amount of 529 funds that can be used for room and board depending on the college. Check with your school for details.
3.) Anyone can open a 529 plan and the beneficiary can be changed once per year.
There aren't any income restrictions to open a 529 account, and anyone can be named as the beneficiary, regardless of how old he or she is. So if you are thinking of going back to school in the future, opening a 529 plan for yourself is something to consider.
The beneficiary of a 529 plan can be changed once per year, as long as it is changed to a different family member, as defined by the IRS. If you save extra funds for one child, they can always be used for a different child or even a grandchild. If you want to start saving before your child is born, you can open a 529 plan in your name and transfer it later. You can even do a partial change of beneficiary to transfer just some funds into a new account.
4.) A 529 plan Will have a very low impact on financial aid...if planned correctly.
Many parents ask if 529 plans will affect their child's financial aid eligibility. And some avoid them because they aren't sure. Yes, a funded 529 plan can affect financial aid, but there are ways to reduce the impact and overall it will still help you more than it will hurt you.
To qualify for financial aid, students complete the Free Application for Federal Student Aid (FAFSA) form. Colleges use this form to calculate a family's Expected Family Contribution (EFC). In simplest terms, the cost of college minus the EFC equals the financial aid given. Therefore, the lower the EFC, the more financial aid a student will qualify for. The question then becomes, how can families keep their EFC as low as possible?
Depending on who owns a 529 plan, it will be counted differently toward a family's Expected Family Contribution.
- Parent and student-owned 529 plans are considered parental assets, only counting toward 5.64% of the EFC, therefore decreasing financial aid by 5.64% of the 529 plan balance. Distributions from these accounts have no impact on financial aid in later years.
- Grandparent or other-owned 529 plans will not affect the EFC while the funds are still in the 529 plan. However, when a grandparent or other owner withdraws the funds to pay for college expenses, the amount withdrawn will be included as student income the following year. That means the student's financial aid can be reduced by 50% of the distribution - Yikes! Does this mean grandparents shouldn't open a 529 plan for their grandchildren? Absolutely not, but they must be sure to strategize when distributing the funds. One way to do this is to transfer the 529 plan to the student or parent, if the plan allows. Another option is to wait to distribute the funds in a student's later years of college.
5.) 529 plans have estate planning benefits.
When you contribute to a 529 account, you retain full control over the assets, and yet the funds are removed from your taxable estate. The value of the account will instead be included in the estate of the designated beneficiary.
For tax purposes, any money saved in a 529 plan is considered a gift. Under current law, you are only allowed to gift $14,000 per year to another before incurring gift taxes. There is a special rule for 529 plans that allows you to elect to contribute five years' worth of contributions in one lump-sum, and forgo making contributions until the five year period has expired. This is commonly referred to as superfunding, and allows you to contribute as much as $70,000 to a 529 plan gift tax free. Depending on how many 529 plans you have, the wealth transfer potential could be substantial, and yet you still have control over the funds. Although superfunding isn't for everyone, it's a great option if it makes sense in your situation. Even if you can't fund the maximum, the idea of funding as much as possible as early as you can will help your child's 529 plan reach its full potential.