At Merriman, we often help our clients plan for more than just retirement. One topic that commonly comes up is saving for college. My colleague, Lowell Lombardini Parker, wrote about the various college savings options in an earlier post, and this three-part series will focus specifically on the 529 plans highlighted in his article. Part I will review 529 plan basics; Part II will evaluate Washington’s 529 prepaid tuition plan, known as the GET; and Part III will take a look at the best 529 savings plan we know – the West Virginia Smart529 Select.
The cost of education
According to The College Board, the average tuition for an in-state student at a public four-year college is $8,244. The tuition cost for an out-of-state student is often more than twice this cost, and a private college may cost over three times the amount. After adding in additional costs for housing, food, books and supplies, it’s not difficult to imagine why the annual cost of education can easily range from $20,000 – $50,000 in today’s dollars. Financial aid and scholarships can help, but most parents will need to be intentional about saving for college if they want their children to graduate without a mountain of debt on their backs.
How 529 plans can help
529 plans come in two flavors: savings plans and prepaid plans. All 50 states have one form or the other, and some states offer both. The benefits and drawbacks of 529 plans typically apply to both.
The primary benefit of a 529 plan is tax-free growth, as long as the funds are used for qualified educational expenses. As an example, $10,000 invested today and growing at a 7% annual average for 18 years will become $33,799 by the end of that period. This growth of $23,799 can be withdrawn and spent entirely tax-free if used for qualified educational purposes—and the definition is fairly broad, including tuition and fees, books, supplies, room and board, meal plans, and even computer equipment and internet access. It can be a huge benefit in coping with the high cost of education.
Although the growth in a 529 account is tax-free, contributions to the accounts are not tax-deductible for federal purposes. However, some states offer a state income tax deduction if you contribute to that state’s 529 plan. Each state manages their plan differently, so it’s important to understand the rules and costs of the plan because the state income tax savings alone may not be worth giving up access to a more flexible or cost-effective plan elsewhere.
Another important benefit of 529 accounts is that the donor remains in control of the assets, even though the value of the account is removed from the donor’s estate. This is especially useful for donors who want to reduce their taxable estate (federal or state, as many states have a lower estate exemption than the current federal estate exemption of $5,120,000) but who also want to ensure the funds are used as intended. Gifts to 529 accounts qualify for the annual gift tax exclusion of $13,000 per donor per donee, and a special provision even allows 529 accounts to be “front loaded” by providing donors the ability to contribute up to five times the annual gift tax exclusion and electing to spread that gift over five years. This ensures maximum growth inside the 529 accounts while eliminating the need to pay gift tax (although a gift tax return is still required to be filed in the year of the front loading).
In addition to maintaining control, assets in 529 accounts are considered assets of the owner for financial aid purposes, which is far more beneficial than having the assets belong to the beneficiary/student. For example, assets in a parent-owned 529 account for the benefit of a child will be assessed at the parent rate of 5.64% when calculating the expected family contribution for financial aid purposes, as opposed to the 20% rate applied to assets belonging to the student. Even better still is to have a grandparent own the 529 account; those assets are not factored into the calculation of expected family contribution at all! This may allow the student to qualify for a higher financial aid award than they might otherwise receive.
The primary drawback to 529 plans – and it’s a big one – is that any earnings withdrawn for non-qualified purposes are taxed at ordinary income rates and assessed a 10% penalty. One concern my clients often voice is, “what if my child doesn’t go to college?” It’s a valid concern, and there isn’t an easy answer. 529 plans do contain provisions that allow for changes in beneficiaries, so if one child doesn’t attend college, you could reassign the funds to a different child or family member (including stepchildren, nephews or nieces, spouses of family members, or even yourself) – but if no one goes to college, you may wind up having to pay the income tax and penalty to withdraw the assets.
It’s a calculated risk, and I advise clients to consider splitting their intended contribution between a 529 account and a regular taxable account as a way to hedge against this risk. They may not be maximizing the potential tax-free growth, but they’re also not stuck with a potentially large account that would be taxed at ordinary income rates, in addition to a hefty penalty, if the child doesn’t go to college.
I encourage you to speak to your financial advisor or accountant if you believe a 529 plan is appropriate for your situation. With the increasingly high cost of education, families need all the help they can get to maximize the value of their money. A 529 plan is a great start.
Written by retired Merriman Advisor Phuc Dang
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