If you are a parent and have been paying attention to the recent news about tax reform, chances are you’re wondering how it impacts you and your tax savings. 529 plans have received a lot of attention due to changes in its utilization. If you’ve been on the fence about whether or not a 529 plan is the right choice for your family, you may want to consider how the tax reform has changed the program.
As a mom of two young kids myself and a financial planner for many parents, I can’t emphasize enough how important it is to save early and often for your child’s education. You can even start saving before your first child is born.
The cost of education is continuously rising. For today’s newborns, the cost of college is estimated to be about $50,000 per year for public school and about $130,000 a year for private school. And, if you plan to send your child to a private elementary and high school, you’re looking at an average of $7,700 and $13,030 respectively.
A common way to save and invest for college is through a 529 plan. These plans have historically allowed you to set money aside for qualified educational expenses such as tuition, fees, room and board, and computers, and other equipment. Now, they can also be used for qualified education expenses earlier in your child’s life.
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How a 529 Plan works
A 529 plan is an educational savings plan sponsored by a state or state agency that may offer a number of investment options and strategies. Any earnings grow federal income tax-deferred and distributions for qualified education expenses are federal income tax-free. If you withdraw money for any other reason, you’ll pay state and federal income taxes plus a 10% federal tax penalty on earnings.
There are different types of 529 plans to choose from, and you’re not necessarily limited to ones based in your state of residence. But before you select an out-of-state plan, see if your state’s offers additional tax benefits. Depending on your state, you may be able to deduct some or all of your contributions from your state income taxes (more than 30 states currently offer this incentive.)
There are two kinds of 529 plans
Prepaid Tuition Plans
These allow you to lock in today’s tuition costs at an in-state public college. You essentially pre-pay for college by buying credits for future enrollment. There are also prepaid 529s for private colleges.
There are some drawbacks to these types of plans:
- For most plans, you have to live in the state that sponsors it
- Some state governments don’t guarantee the money you save in a prepaid plan, which means you may lose some or all of your money if the plan’s sponsor has a financial shortfall
- If the beneficiary ends up going to an out-of-state school, the prepaid plan may pay out a smaller amount than they would have if the beneficiary remained in-state
- Room and board doesn’t count as a qualified educational expense under these plans.
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These can accounts offer some additional flexibility. You can use them to save up for qualified educational costs at any college or university (and now you can use them for private school, too — more on that shortly.)
Here are some things to know about these plans:
- You can choose a plan from a state other than your state of residence.
- The donor controls the account and there are no income limits to establish a 529 plan.
- The beneficiary can use these funds for in-state, out-of-state, and sometimes even non-U.S. schools.
- The money in this type of 529 can be invested in a variety of investment vehicles. Depending on investment performance, this may allow your savings to grow at a higher rate than they would in a prepaid plan.
- Investments in college savings plans are not guaranteed by state governments and could lose some or all of the money invested.
- Room and board count as a qualified educational expense.
- NEW: You can now withdraw up to $10,000 per year per student for private education in grades K-12
Advantages of a 529 Plan
Beyond the double benefit of tax-deferred investment growth combined with tax-free withdrawals for qualified expenses, there are a number of advantages to saving in a 529 account.
A brand-new benefit is that you can now use 529s to save for private school tuition for kindergarten through 12th grade. This provides tax savings for parents who plan to send their kids to private school. You can withdraw up to $10,000 per year, per student for this purpose.
Additionally, you can set up an unlimited number of plans, and there are no rules on who the beneficiary can be. That means you can create an account for a relative, friend, or yourself. There are also no income limits, so your contributions aren’t phased out if you earn over a certain income. Other people can also contribute to your child’s account, making it easy for family and friends to gift money toward your child’s education.
The maximum that can be saved in your 529 account depends on the state sponsoring your plan. This can range from around $200,000 to around $550,000. How much you choose to contribute per year comes down to how much you can give before paying gift taxes (otherwise known as the annual exclusion.)
How you can avoid annual exclusion:
- You can gift up to $15,000 per year to your children or anyone else without a gift tax liability. If you’re married, you and your spouse can gift-split and give up to $30,000 per person, per year.
- In the case of 529s, you can make five years’ worth of contributions at once ($75,000 for an individual, $150,000 for a married couple) before being liable for the gift tax.
- If the current beneficiary doesn’t use all the money in the account for their education (or decides not to use the money at all), you can transfer the account to another family member with no tax consequences. That also makes it easy to begin saving before your child is born, because you can create an account for yourself, and then change the beneficiary to your child later.
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Disadvantages of a 529 Plan
While a 529 plan remains a great way to save for college or private school, it lacks the flexibility of other accounts because you can only make tax- and penalty-free withdrawals for educational costs. You’re basically earmarking this sum of money for education only. Therefore, if you use the money for non-qualified expenses, that leaves your earnings subject to federal income taxes plus a 10% federal tax penalty on earnings.
There also aren’t a ton of investment options available in 529 plans. And, unlike other investment accounts, you can’t change your allocations whenever you’d like. You’re limited to two investment option changes per year, and whenever you change the beneficiary, you’re granted one more investment change.
In addition, a 529 is taken into account when you apply for financial aid, and it may impact your child’s ability to qualify for need-based aid.
How else can you save for education costs?
A taxable investment account
You can invest over a long period of time for college in a brokerage account. The downside is that you won’t get the tax advantages of a 529, but the upside is that you can use the money in that account for any purpose.
A Roth IRA
These are typically used to save for retirement, but can also be used for education costs. In a Roth IRA, you can withdraw your contributions tax- and penalty-free. You can also withdraw any investment earnings, but you’ll pay income tax on that money, and there are other requirements around the withdrawal in order for it to qualify for tax-free treatment. The contribution limit for a Roth IRA is $5,500 per year, which puts it at a disadvantage to a 529, where you can contribute significantly more.
Uniform gift or transfers to minors were more popular before 529s were created in the mid-1990s. There are potentially some significant downsides to these kinds of accounts. First, they are not tax-deferred; however, in some circumstances, taxation may be at the child’s tax rate, which is lower than the parent’s rate. Second, the money you transfer into an UGMA/UTMA is irrevocable and the parent gets no say in how the child uses the money in the future (meaning the child may not go to college and spend this money elsewhere, against the parent’s wishes.) Third, when it comes to applying for financial aid, a 529 is considered the parent’s asset, but an UGMA/UTMA is a child’s asset. Any asset belonging to the child is weighed more heavily when determining financial aid needs.
Do what works for you
There’s no universal right answer to how you should save for your kid’s college education. You can put all your eggs in one basket with a 529, or you can spread them out to take advantage of the features of other savings plans and investment accounts.
I have some clients who put their full force behind funding a 529 plan, while others opt to split their savings 50% into a 529 plan and 50% into a separate taxable investment account.
For our family, I prefer to split savings 50/50 between taxable investment accounts and 529s. This allows us to prepare for the chance that our children might not go to college. Therefore, if they need funding for a business or entrepreneurial idea instead, we can still assist them.
Either way, take the time to research each option, dig into the details of the tax incentives and fees, and work with a financial planner (if necessary) to make the right decision for your situation.
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Mary Beth Storjohann, CFP® and Founder of Workable Wealth, is an author, financial planner and accountability partner working to help clients in their 20s-40s across the country make smart, educated choices with their money. Her recent accolades include the “Top 40 Under 40” by Investment News, “10 young Advisors to Watch” by Financial Advisor Magazine, and “10 of the Best Personal Finance Experts on Twitter.” She frequently appears on NBC as a financial expert and her expertise has been featured in The Wall Street Journal, CNBC, Forbes and more.
The opinions expressed in this article are the author’s own. Haven Life Insurance Agency offers this as educational information. Haven Life does not offer investment or tax advice and encourages you to seek advice from your own legal counsel or tax professional.
Haven Term is a Term Life Insurance Policy (ICC15DTC) issued by Massachusetts Mutual Life Insurance Company (MassMutual), Springfield, MA 01111 and offered exclusively through Haven Life Insurance Agency, LLC. Not all riders are available in all states. Our Agency license number in California is 0K71922 and in Arkansas, 100139527.