What do I need to know about 529 plans?
Whether your child is in middle school or a newborn, it’s a great time to think about how you’ll cover her education costs. For families with higher income and net worth, Section 529 plans are the most popular vehicles to fund not just college tuition, but private kindergarten through high school expenses as well.
529 plans are popular mainly thanks to:
Tax advantages of contributions and distributions
The amounts you may deposit on a yearly basis
The control the contributor may have in the plan
529 plan, defined
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. They’re sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.1
How much can we contribute to a 529 plan? (And what about gift taxes?)
If you’re a single filer, you can contribute up to $15,000 per year without incurring gift taxes. And if you’re a married couple filing jointly, the amount jumps to $30,000 per year. Beyond that amount, you’ll have to pay gift tax.
There is, however, a way that you can contribute $75,000 in one year ($150,000 for married joint filers) and have that gift treated as if it were made over five years at $15,000 ($30,000) per year, and free of gift taxes. You can’t contribute any more until five years have passed, unless you’re willing to pay gift taxes, or unless the annual gift tax exclusion gets increased.
Let’s look at the pros and cons of 529 plans.
Income tax benefits
- When used for college or K-12 qualified expenses, earnings are not subject to federal income tax.
- If not used for qualified expenses, federal income tax on the earnings is deferred until distribution.
- Many states offer a state income tax deduction for contributions to those states’ 529 plans, making it attractive for their residents to choose their plan over those offered by other states. Some states even offer tax deductions on contributions to other plans.
- Unlike any other gifts, you can retain control over your gift with no “bad” estate tax consequences. You can also change the beneficiary to certain family members with no tax consequences, or take the funds back (subject to a 10% additional tax on earnings).
- Parents are not the only ones who can set up 529 plans for their children. Grandparents, siblings or even friends can contribute to a 529 plan even if they are not the account owner.
- You can contribute to a 529 plan in any state, not just the one you live in. For example, if you live in Pennsylvania, and Utah’s plan will be more beneficial than Pennsylvania’s, you’re permitted to use a Utah 529 even though you don’t live there.
You can contribute using the annual exclusion for five years (front-loading). Example: You contribute $75,000 to a 529 account for your daughter in 2019 and treat the contribution as made using your $15,000 annual exclusions for 2019, 2020, 2021, 2022, and 2023. The advantage of front-loading is that earnings can begin to build tax-free faster than if you made separate contributions each year.
10% additional income tax
If not used for college expenses, there is a 10% additional tax on earnings.
If not used for qualified expenses, all earnings are taxed as ordinary income (even if the “actual” earnings were capital gains).
The management fees for a 529 account are higher than the fees for comparable mutual funds.
Less flexibility in investments
The investment vehicle can be changed only once per year, and the choices are limited to certain managers.
No discount on gifts
If an individual is choosing between a gift of an asset that can be discounted (such as partial interest in real estate) and a gift to a 529 plan, he/she can transfer “more” through gifts of real estate (which can be discounted).
Decreases ability to reduce estate
- If you make annual gifts to a child (rather than to 529 account), you can pay college expenses out of your own pocket, and thereby, reducing your estate. Note: In this case, your estate is reduced by annual gifts and by college expenses.
- If you make annual gifts to a 529 account for a child and pay college expenses from the 529 account (rather than out of your own pocket), your estate is reduced by annual gifts, but not by college expenses.
What to consider before choosing a 529 plan.
The size of your estate
If you fall in the moderately wealthy category and are not making annual exclusion gifts, there’s no estate disadvantage and you get the income tax benefit (assuming funds are used for college expenses), as well as a possible estate tax benefit (because the estate is reduced by the annual gifts to the 529 account).If you’re considered “moderate means,” you may be more focused on saving for retirement than your child’s education, and a 529 plan may not be ideal for you. In addition, a 529 plan may affect your child’s ability to qualify for financial aid (federal, state or the educational institution’s).
The age of the children
The younger the child, the better; this gives you more time for tax-free buildup.
Equalization among children
Use this with caution. Example: Grandma has given $500,000 to her 10-year-old grandchild and has used her entire unified credit on this and other gifts. Another grandchild is born and now Grandma would like to try to make her gift to this child equal to the other’s gift. Grandma can use her annual exclusions to contribute $15,000 to 529 accounts for both the 10-year old and the newborn, but then direct the entire distribution to the newborn down the road.
How to select the right plan for your family’s needs.
So, you’ve decided a 529 plan is the way to go. Now — how do you select the right one? They’re not all the same, and you don’t have to choose the one your state sponsors. Let’s take a look at the relevant factors.
The first place to look is your home state. Some states offer special tax benefits to their residents (like a state income tax deduction for contributions to the 529 plan of that state) and/or lower fees for residents.
Fees can have a major impact on the performance of a 529 account. Look for plans with low fees — anywhere from 0.13% to 0.89% is good. States with plans in this range include Utah, New York, Iowa, Michigan and Nevada.
Choice of funds
While fees are important, different 529 plans have different kinds of funds available. It’s crucial to examine these choices and track record of the funds.
If creditor protection is a major issue, be sure to review this aspect of each plan. Alaska and New York (and perhaps other states) have special provisions for creditor protection, subject to certain restrictions.
States have contribution limits ($300,000 and up in most states), and others raise their limits each year to keep up with rising college costs. Some plans also may have a contribution limit, both initially and each year.
A real-life 529 plan analysis
We compared two plans2, 3 to find out where a hypothetical family, the Chens of Washington, come out when considering a plan for Riley, their toddler. We took a look at the specifics of two state plans – their home state of Washington, and Utah’s plan, which is a popular option.
Download the full article to see the details of our analysis.Download PDF
Talk with your financial advisor when you’re ready to consider a 529 plan. You’ll have a lot to think about before determining whether a 529 plan is right to finance your children’s education and then finding the plan that’s right for you. Your financial advisor can help you structure a plan that best fits your needs.
1 Securities and Exchange Commission, "An Introduction to 529 Plans" May 29, 2018
2 Fee range is approximate as they change periodically.
3 my529.org (Utah Educational Savings Plan). Accessed on January 9, 2019 at savingforcollege.com/529-plans/utah/my529
The material included herein is based on the views of SIMC. Statements that are not factual in nature, including opinions, projections and estimates, assume certain economic conditions and industry developments and constitute only current opinions that are subject to change without notice. Nothing herein is intended to be a forecast of future events, or a guarantee of future results. This presentation should not be relied upon by the reader as research or investment advice (unless SIMC has otherwise separately entered into a written agreement for the provision of investment advice).
Neither SEI nor its affiliates provide tax advice. IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein. You should seek advice based on your particular circumstances from an independent tax advisor. The information contained in this communication is not meant to substitute for a thorough estate planning and is not meant to be legal and/or estate advice. It is intended to provide you with a preliminary outline of your goals. Please consult your legal counsel for additional information. This is intended for educational purposes and not meant to be relied upon as investment advice.