The federal government made some changes in December 2017 to the tax plan which impacts the 529 College Plan and the 529a ABLE account. One interesting example is that now 529 funds may benefit youth in K-12. This plan change has gotten a lot of attention. (Notably, because previous to this, the funds could only be spent on college related expenses. Now the funds are able to be used for such expenses as private school education.)
But before we discuss these and other 529 changes, I’d like to take a step back and focus on some 529 basics…
What is a 529 Plan or Account?
Plain English
It is a way to save money for school related expenses:
- The financial gains in these accounts are not taxed.
- Some states offer a state income tax incentive like a deduction for those that contribute.
- If the funds are used for qualified school expenses then the money is not taxed when its taken out of the account. (Ideally money should be sent directly to the school institution).
Formal/Detail Explanation
A 529 plan is a tax-advantaged educational savings plan that is sponsored by states, state agencies or educational institutions. This plan is named after section 529 of Internal Revenue Code and its savings can be used for pay tuition fees, buy books and other educational related expenses.[1] Until now, one was able to use 529 savings to pay for US vocational-technical schools, any accredited two – and four – year universities and colleges as well as any eligible foreign institution. Basically, there are two types of 529 plans, a college savings plan and prepaid tuition plans. Most US states and the District of Columbia sponsor at least one of these plans if you meet their minimum requirements. [1] In addition, some private colleges and universities sponsor the prepaid tuition plan. Therefore, if you are planning to start saving for your college funds, you should at least confirm with your state and relevant authorities.
Who can open a 529 plan?
There are no income restrictions as to who can open a 529 plan. However, you need to:
- be a US resident who is 18 years of age or older,
- have a US mailing and legal address, and
- have a Tax ID or a social security number. [1]
The 529 plan is fairly accessible and easy to open. The federal incentives that currently benefit all the 529 accounts make the funds free from federal tax as long as the money is used for a qualified expense. In addition only the following seven states are holdouts on offering any form of state income tax benefits. (The others either don’t have a state income tax like Texas and Florida or the respective state offers an state income tax incentive for participating in the state’s 529 plan):
- California
- Delaware
- Hawaii
- Kentucky
- Maine
- New Jersey
- North Carolina
In fact there are six states that offer a state tax deduction to individuals who contribute to a 529 plan even though it may not be their resident’s 529 plan! Kudos to Arizona, Kansas, Minnesota, Montana and Pennsylvania for being pioneers and forward 529 thinkers and taking this step!
Types of 529 Plans
Plain English
Some states allow one to put money aside for college using today’s college prices. (This is a big deal because college costs continually go up. These programs allow one to lock-in to current college tuition numbers.) The downside to these plans in that they are usually very limiting. For example, it may be limited to a specific network of schools.(What happens if you don’t get in? or decide to go elsewhere?)
Due to the fast rising costs of college education, a number of states have closed or began to phase these programs out. Bottom line, someone; the state college system or state treasury would be left with a hefty college gap in tuition expenses between what these individuals paid and the current cost of educating these students in the future.
- Prepaid tuition plans
Details
This plan allows the account holder to purchase credits or units at colleges and universities that have a 529 plan. The credit bought can then be used for future tuition fees and other mandatory fees in the college or university by the beneficiary. Therefore, if you have a prepaid tuition plan, you cannot use it to pay a room or board in a college. [1] It is important to understand that, although prepaid tuition plans are not guaranteed by the federal government, most of them are sponsored by state governments and require you to have residency requirements. Also, if the beneficiary does not attend the participating college or university, the plan may end up paying fewer tuition costs than if the beneficiary attended a participating college/university.
- College savings plan
This type of a plan allows a college saver to save funds for college on behalf of a beneficiary. The savings can be used to pay tuition, other mandatory fees, room and board. Using this type of a plan offers a college saver a wide range of investment portfolios to choose from. (Unless one’s state offers a tax benefit for participating in their own state’s 529 plan, I am biased towards the Utah College Savings Plan. click here to learn why)
These options may include:
- exchange-traded fund (ETF) portfolios,
- age-based portfolios,
- static fund portfolios,
- mutual fund and
- a principal-protected bank product. [1]
State governments sponsor all college savings plan but only a few require residency requirements of the saver and/or residency requirements of the beneficiary. However, just like other investments, money placed in college savings plans, may not make any money and may even end up losing some or all money invested.
The risk of money loss is a very real risk which must be understood and considered before exposing/investing this money. This reality and determinant factor has a lot to do with the personal risk tolerance of the person putting the money in the account. There may be years until the funds in this account may be used. It would help to know when this money may be needed, are we looking to support a 16 year old- hence the money will be needed in 2-3 years or is the beneficiary 3 months old which will extend the timeline by approximately 17 years. These factors should have an impact on the choice of investments; discussion about risk reward coupled with time factors should be addressed with a financial professional.
Benefits of 529 plans
- The donor, remains in control of the account.
In most cases, the named beneficiary does not have any legal rights to the money saved in 529 plan. (as opposed to a UTMA or a UGMA- since this is really the minors funds, minor can take issue with an adult who made irresponsible decisions with “their money.”) Therefore, the donor or account owner can rest assured that the money saved will be used for the way they he/she decides.[2] The account owner, may withdraw money from a 529 plan at any given time for any given reason. But, if the money was withdrawn for non-qualified educational expenses, the earnings may incur a 10% penalty along with having the earnings itself taxed.
- The plans require low maintenance.
Enrolling is fairly simple. (As always I suggest individuals seek the advice of financial professionals to review the plan of action.) The actual process of opening a 529 plan may be done online. Before deciding on a plan. Consider:
1)Does your state offer a deduction to its residents?
2)What are the fees involved in opening and maintaining the account?
3)Take a look at the investment options.
It may pay to do a little research, for example, New York State has two 529 plans. Unless one’s state offers a tax benefit for contributing to a 529, there may be no strong reason to participate in the local state plan. Instead, look for other plans that offer better “low cost” investment options and lower fees. I have explained before, I am biased toward the Utah plan.- ) [2]After you have enrolled, many plans offer automatic deposit options to help make the regular contribution as seamless as possible. Check out SavingForCollege.com 529 study of fees for a comprehensive list of 529 accounts and their fees.
Once the account is set up, there is a limited amount of maintenance required. It is a good idea to review the monthly or quarterly statements to make sure there are no anomalies and a formal review at least once a year. (The question is what are you looking for when you do such a review. Click here to get a 529 annual review checklist).
iii. 529 Plans Offer Unsurpassed Income Tax Breaks
Even in the states that don’t offer state tax deductions for the contribution, there is a great benefit to having the 529 earnings be tax-free and are also not taxed when funds are used (as long as it’s a qualified education expense. For a list of qualified education expenses click here.)
In the event that tax breaks (as of February 2018 there are only 7 states that don’t offer state income tax deductions- obviously, this can only apply if the state has an income state tax) are not available, time may be the strongest vehicle to help the funds grow. The longer the funds are invested the longer the opportunity the money has to grow or even weather a dip – which should be considered as part of the stock market’s organic natural investment cycle. [2]
- Your State May Also Offer Tax Breaks
Besides benefiting from federal tax savings, more than 30 states in the United States now offer partial, full or credit to 529 plan contributions. (for a full list of the states that offer state income tax benefits click here) [2] One might think it is important to research about 529 plans in your state before you start saving for college.(this may cause another delay or stumbling block to those that may be motivated to take action). It may behoove a motivated saver to put money into any 529 (may opt for FDIC insured 529 savings or checking account) and then in the event that a more attractive plan catches your fancy, then one may transfer funds to another plan.
- 529 Plans Have Simplified Tax Reporting
You don’t need to make regular reports on your federal tax return about contributions made to a 529 plan. [2]In fact, you only receive Form 1099 the year you make your withdrawal to document any taxable or non-taxable earnings. It’s recommended that one consult a financial professional or 529 plan support before making a withdrawal- this will help to avoid costly errors.
- 529 Plans Are Flexible
It is possible to change your 529 plan investment option twice a year. There are two benefits to having this option:
- Rebalancing or changing the investment the 529 money is in. (It is your money, an owner or donor to a 529 account shouldn’t feel trapped. On the other hand having this limitation in place curtails poor and potentially irresponsible behavior- after all the purpose of this money is education which is hopefully considered a long-term “play”.
- With this flexibility, you can, therefore, roll over your earnings (funds) into another 529 plan once within a period of 12 months. [2] This option is there to help people who would like to change their plans after starting one. (It is a good idea to consult with a financial professional about this). It is possible to make a mistake initially and only to know about it once you’ve already started saving. It is important to understand that there is no federal limit to the number of times you can make these changes provided the account beneficiary is replaced with another qualifying member of the family.
vii. 529 Plans Are Open to Everyone
Everyone is eligible to benefit from 529 plans,unlike Coverdell Education Savings Accounts (ESAs) and Roth IRAs, 529 plans do not have age limits, income limits and annual contribution limits. [2]There are different 529 plans designs (by state) and their lifetime contribution limits vary depending on the plan you have chosen. You should, therefore, take your time to understand the different types of 529 plans, their pros, cons and limitations to help you make the right choice.
The New 2018 Changes in 529 Plans
Initially, 529 plans expenses may be used to for tuition, housing, computer software and equipment at any post-secondary institution which is eligible.
Now with the new tax bill, 529 plans can be used in to pay private elementary and high schools. [3] A while ago, Education Savings Accounts (ESA)’s were the only vehicles that offered tax-free savings for K-12. [4]Nowadays, ESAs and 529 plans are quite similar regarding tax-free withdrawals and tax-free earnings growth although there are differences between the two. The main differences between ESAs and 529 plans are:
- 529 plans do not have any income limits. However, for individuals to be eligible in Coverdell ESA he or she must earn less than $110,000. If they are married and they are filing jointly, they should earn less than $220,000.
- While Coverdell ESA have contribution limits of $2,000 per beneficiary, 529 plans do not have any contribution limits.
- In Coverdell ESA, contributions must be made before the account beneficiary is 18 years of age. On the other hand, 529 plans do not have any contribution deadline.
- 529 plans do not have account time limit while in Coverdell ESA, the funds in the account should be used before the beneficiary turns 30 with the only exception being when the beneficiary has any special needs.
An investment account that is tax-advantaged for K – 12 is not entirely new because Coverdell ESA has been offering tax-free investing for K-12 and for higher education expenses since 1998. [5]The only difference was that the tax-advantaged accounts were only for individuals who were within certain income limits.
With the current possibility of paying for K – 12 expenses using a 529 plan, you may think of rolling over your Coverdell ESA account. With a 529 plan, you can make a contribution of up to $15,000 (in 2018) without triggering gift tax nor have an income limit.
Although lifetime limits will depend on the plan you have chosen, you can continue making contributions in 529 plan even while the student is in college and even after that because there is no requirement to withdraw the funds after a given period of time.
Deductions
The GOP Tax bill allows parents to use up to $10,000/year from 529 plans in K-12 expenses i.e. paying for private school tuition and books through 12th grade while still using their 529 account proceeds to pay college costs. It is also possible for individuals to save on state and gift taxes while still making contributions to 529 plans. As discussed above, more than 30 states either offer deductions or credit to contributions made to 529 plan. It is important to note that potential benefits vary from one state to another although deduction limits range from $500/year for each individual to the total contribution made of $15,000.
Example:
A family that resides in New York State is eligible for a $5,000 individual and $10,000 joint deduction for 529 plan contributions. The parents of a 5th grader who attends private school want to consider taking advantage of this 529 state income tax deduction. The private school tuition for their child is currently $10,000. Each year the parents have contributed $5,000 into a 529 Plan.
In 2018, the parents decide to put $15,000 into their 529 plan. As joint filers the parents automatically receive a $10,000 tax deduction from the state of New York. (If this family was in the 25% tax bracket that would mean a $2,500 savings.)
This family has many options but we will depict 2 for the purpose of illustrating the impact of their options.
- Suggested Option 1: The family decides to take $10,000 and pay for their child’s private school tuition and keep the $5,000 in the account to grow toward their child’s college expenses. In this option, the family didn’t spend more on the child’s tuition/education expenses than they did in the past because they pay $10,000 toward private school tuition and $5,000 in a 529 plan. Yet they earned a $10,000 deduction.
- Suggested Option 2: The family decides to pay the private school tuition $7,500 from the 529 plan. They keep $7,500 to grow in the 529 toward their child’s college expenses. They also decide to pay the balance of the private school tuition using the $2,500 that they saved from the $10,000 NYS income tax deduction -this is money they would have paid out anyway.
Many states offer partial or full state tax deductions besides federal tax benefits to contributions made to 529 plans. [5]More than 30 states including District of Columbia have such 529 plan incentives. Six of these states offer their residents deductions for contributions to any state’s 529 plan. These states are Minnesota, Kansas, Arizona, Pennsylvania, Missouri and Montana. One benefit residents of these states have over the others is the freedom to choose the state plan which has the lowest fee. They also have the freedom to choose the state that has the best investment options while still getting a tax deduction. Out of these states, Pennsylvania offers the best incentive because it allows a deduction of up to $13,000 per beneficiary per contributor ($26,000 for a married couple that is filing jointly). If you choose any other state that is offering tax deductions, you will only be eligible to deduct the amount contributed to their state plan. The right choice is choosing the state that offers the biggest deductions. However, even if you qualify for a state tax deduction, it is advisable you contribute the annual deductible amount into your home state plan to pay for K -12 and then look for another state that has diverse investment options for college savings. New Mexico, South Carolina and Colorado are the only states that allow you to deduct your contributions full amount with respect to their 529 plans. This is rare because most states have a specific dollar limits on 529 deductions.
Currently, seven states have income tax and yet do not offer deductions for contributions made to 529 plans. These states include California, New Jersey, Maine, North Carolina, Delaware, Kentucky and Hawaii. [6]While tax deductions can make a state plan attractive, you should not make tax deductions your main factor to consider because there are other factors to consider too. Some parents that are using the 529 plan to save for college, have opened a second 529 plan account for their K-12 needs. This way their savings are segmented and not “commingled.” This will not only help you keep track of each objective you set but also select the right investments depending on your withdrawal schedule.
ABLE Account Rollovers
ABLE accounts were introduced in 2014 with an aim of helping Americans living with disabilities save for their education and other living expenses. ABLE accounts usually offer tax-free withdrawals and tax-free investment growth when the funds are used to pay qualified expenses e.g. job training, financial management, college, healthcare among other expenses. The new tax plan allows existing 529 plan savings to be rolled over into an ABLE account. [7]This is very helpful especially when a parent or a guardian wants to change the plan they are using. Parents had limited options after starting to save for their child’s college education only to learn that he or she has a disability after they’ve started saving. Before December 2017, there was nothing to do. The money in the 529 plan wasn’t easily used to benefit their child with special needs. If the parents did decided to use the 529 funds for their special needs child in an unqualified expense, the event would trigger a 10% penalty and a tax liability.
As of December 22, 2017 when the tax reform bill impacted the 529a ABLE program. Among the three changes that impacted the ABLE accounts, now according to Disability Scoop “under the new tax law, people with disabilities will be able to roll over funds from a traditional 529 college savings plan to their ABLE account”. Although it has been signed into law, the individual states that manage their respective 529 ABLE plans have yet to implement this change.
Reference links
- http://www.savingforcollege.com/intro_to_529s/what-is-a-529-plan.php
- http://www.savingforcollege.com/intro_to_529s/name-the-top-7-benefits-of-529-plans.php
- https://www.sec.gov/reportspubs/investor-publications/investorpubsintro529htm.html
- https://www.forbes.com/sites/reneemorad/2017/12/31/the-529-plan-change-that-could-help-families-save-on-education-and-taxes/#b2a5f069a921
- https://www.nytimes.com/2017/12/21/your-money/529-plans-taxes-private-school.html
- https://www.cnbc.com/2017/12/29/tax-bill-529-plan-provision-helps-families-save-on-school-costs-taxes.html
- http://www.savingforcollege.com/articles/coming-soon-big-changes-to-529-plans
