Saving for College
Published On: October 5, 2018
Written by: Ben Atwater and Matt Malick
In addition to funding retirement, education is also a leading goal for many investors. Whether you are a grandparent saving for a grandchild, an aunt saving for a niece or, most commonly, a parent saving for a child, the 529 plan is likely a useful vehicle.
Since its creation in 1996, the 529 plan has become the most popular college savings vehicle for American families. And recent tax law changes now permit broader use of these plans for elementary and secondary education expenses as well.
A 529 plan, typically sponsored by states, is a vehicle for families to build assets to fund future education costs. Two distinct types of 529 plans exist: prepaid plans, which permit participants to pre-pay for future college expenses; and savings plans, which allow participants to invest in mutual funds.
These investment vehicles offer several benefits, but the primary appeal is tax-free growth. Participants can ultimately withdraw “qualified” distributions tax-free. While your contributions are not deductible on your federal tax return, residents of certain states, including Pennsylvania, are allowed a current deduction in calculating state income taxes.
Additionally, anyone can fund a 529 plan, regardless of age, income and relationship to the account beneficiary. Plan contributions are classified as gifts, so a person can make contributions of up to $15,000 in 2018 without filing a federal gift tax return. Moreover, an exception exists that allows for the prefunding of five years of gifts ($75,000) in one lump sum without filing a federal gift tax return.
For grandparents looking to contribute to college savings, be careful how contributions are made. If the grandparent owns the 529 account, as opposed to the grandchild’s parent, then distributions from the 529 may be considered “income” for the purposes of qualifying for student aid. In most cases, it makes better sense for the grandparent to contribute directly to a 529 owned by the child’s parent.
It is important to note that there is a 10% penalty for withdrawing earnings from a 529 plan when you don’t use the funds for qualified education expenses, in addition to paying income tax on those earnings. However, most 529 plans allow a change in beneficiaries. So, if the beneficiary decides not to attend college, one can transfer the account to a new individual who is directly related to the original beneficiary.
Prior to 2018, plans required that owners apply qualified 529 plan distributions toward post-secondary education expense, including tuition, fees, textbooks, supplies, and equipment.
Following Congress’s passage of the Tax Cuts and Jobs Act last year, owners may now also apply 529 plan dollars toward tuition at private, public or parochial elementary and secondary schools. It’s important to note that Congress limited these newly qualified expenses to tuition only (no fees, books, etc.) up to $10,000 per year, per student.
Recently, the Ways and Means Committee of the U.S. House of Representatives released language describing a “Tax Reform 2.0” bill, which would additionally allow 529 plan owners to apply distributions toward repaying student loans. For now, however, you cannot tap 529 plans tax-and-penalty-free to repay student loans.
From an investment standpoint, for savings plans where investors select mutual funds, we advise 529 plan investors to focus on creating an appropriate asset allocation given the beneficiary’s time horizon and minimizing fees.
For a young child with more than ten years until college, consider a stock-heavy portfolio to allow for growth. For a young teenager with five years or less, bonds, cash and a small allocation to equities may be more appropriate in order to protect principal. Time frames in between likely call for a more balanced asset allocation. Seek the help of a fee-only investment advisor for guidance in developing an asset allocation strategy.
Next, choose a low-cost plan that includes diversified index funds, regardless of which state sponsors the plan. A Pennsylvania resident is free to participate in any state’s plan and still receive a state income tax deduction. Fidelity offers a New Hampshire-domiciled plan that includes index funds that adjust their allocation based on the beneficiary’s age.
Much like retirement, children’s education is a major investment for many American families. Therefore, it pays to start early, invest appropriately and take advantage of the tax benefits offered by 529 plans.
Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.