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Section 529 plans are arguably the best college savings vehicle around. In this article, we will cover what 529 plans are, why they make such great college savings accounts, and how high net worth investors can take advantage of 529 plans for their estate planning tax benefits.
Legally known as “Qualified Tuition Plans”, Section 529 plans are tax-advantaged savings accounts designed to incentivize individuals to save for education costs. In other words, if you want to save for your child’s, grandchild’s, or anyone else’s future schooling, consider saving into a 529 plan. Here is a quick rundown of some frequently asked questions regarding 529 plans:
Each 529 plan has an owner and a beneficiary. The owner opens the 529 plan, decides how much and how often to save into the account, determines how it is invested, and selects the beneficiary. The beneficiary is the person who uses the funds in the account to pay for their education costs. Note that the owner can elect anyone to be the beneficiary of the 529, the two do not have to be related, and the owner can change the beneficiary at any time.
529s are funded with after-tax money so you do not receive an income tax deduction on contributions. However, the money grows tax-free inside the account and is withdrawn tax-free so long as it is used for qualified education expenses. In some cases, you may receive state income tax deductions for 529 plan contributions.
There are no annual limits on 529 plan contributions. Instead, 529 plans have aggregate contribution limits set by each state that range from $235,000 to $500,000. If the 529 plan’s balance hits the state’s limit, you can no longer make contributions to the plan, however, the account may continue to grow and accrue earnings. There are also no income limits on 529 plan contributions.
People often have the misconception that the maximum amount they can save into a 529 plan is $15,000 per year. However, it is the annual gift tax exclusion — the amount an individual can give each year to any one person without running into gift-tax implications — that is capped at $15,000. There is nothing unique to 529 plans preventing you from contributing more than the annual exclusion besides the aforementioned state aggregate limits. That said, if you do contribute more than $15,000 in one year, you must report the excess amount on the Form 709 Gift Tax return, which counts against your lifetime estate and gift tax exemption amount, currently sitting at $11.7 million. Keep in mind that any amounts in excess of the lifetime exemption could trigger gift taxes up to 40%. Other alternatives exists to “superfund” your 529 plan without eroding your lifetime exemption that will be discussed later in this article.
Fortunately, the IRS’s definition of a qualified education expense is relatively broad and includes things like tuition, books, school supplies, computers, certain room and board costs, and K-12 private school tuition up to $10,000 per year. Examples of non-qualified expenses are transportation, insurance, and room and board if the beneficiary is not at least a half-time student. If you are unsure about what meets the definition of a qualified expense, check with your financial professional; 529 plan money used to pay for non-qualified expenses will be taxed as income on earnings and be charged a 10% penalty.
There is no one size fits all answer to this question. Determining how much to contribute, and when to contribute, to a 529 plan comes down to a multitude of factors, including how old the beneficiary is, when they plan to go to college or private school, your risk tolerance, your cash reserve, your current cash flow, your personal preference around funding certainty, and many other variables. At Stratos Private Wealth we work closely with clients to develop customized funding strategies taking into account each of these factors. If you have any questions, or would like us to run an education-needs analysis for you, please reach out to one of our advisors.
Since the benefit comes from tax-free investment growth, the sooner you get started the better. This allows more time for the account to grow and benefit from the power of compound interest. You may even consider funding a 529 before your child or grandchild is born. 529 plans permit owners to change the beneficiary of the plan, so you could open a 529 under your own name, fund it, and then switch it to the child’s name.
Because 529 plans are typically funded well before the beneficiary knows which school they will attend, and because money leftover in a 529 plan after graduation may face taxes and fees, it can be hard to know exactly how much to contribute into a 529. One approach that has worked well for many Stratos Private Wealth clients is the “Price is Right” strategy – try to identify the amount as close as possible to what will be needed for school costs, without going over. An experienced financial advisor should be able to help you comfortably project the future cost of your child’s education costs, alongside how your 529 plan’s investments may perform in normal market conditions, to estimate an appropriate funding amount.
If you find yourself with money left inside a 529 plan after graduation, since you can change the beneficiary, it can go to another person’s education needs. If you have more than one child, we often recommend being more aggressive with the funding of your first child’s plan and then rolling the excess over to another child. This allows for maximum growth. Also, you will not be penalized if you make nonqualified withdrawals as the result of the beneficiary’s death, disability, or receipt of scholarship.
There is no upfront tax break for contributing to a 529 plan; the major benefit is tax-deferred growth. If the time from when you contribute to a 529 plan and when the beneficiary intends to start school is relatively short — say less than three years — it may not be worth contributing to a 529 plan. The better option may be keeping that money liquid in a bank account or high-yield savings account. Not to mention, with such a short time horizon, the account should be invested rather conservatively, further hindering the potential of tax-deferred growth. If you are on the fence about funding a 529 plan it is advised to consult your financial advisor.
There are technically two different types of 529 plans: prepaid tuition plans and college savings plans, however almost everyone uses a college savings plan because they have fewer limitations. Each state has its own college savings plan, and each plan has slightly different rules, fees, and investment options. We recommend shopping around to find the right plan for your situation. Talk to a financial advisor if you have any questions or need help deciding, and keep in mind that do not have to go with the 529 plan of your domicile state.
Many people come to Stratos Private Wealth seeking investment education for their 529 plans and we often begin by steering them away from thinking about their 529 like they do their normal investment portfolio (i.e., market timing, rebalancing, fund and sector projections, etc.). Instead, think about a 529 plan like a 401(k). Just like employer-sponsored 401(k) plans, state-sponsored 529 plans offer a fixed menu of investments that include an array of mutual funds, separately managed accounts, and equity-indexed funds. 529 plans do not allow you to invest in individual stocks or bonds.
We recommend investing your 529 closely in line with your risk tolerance and time horizon. The further out the beneficiary is from going to college, the more aggressively the 529 should be invested, as reflected by a greater percentage of equity-focused funds that offer a greater return potential while still leaving the account plenty of time to recover if financial markets falter. The closer the beneficiary gets to the first day of school, the more you should shift the allocation to safer investments like bonds and cash. This gradual transition from high-risk, high-reward equities towards principal preservation is commonplace for financial experts, but may be less familiar for everyday investors. Fortunately, most 529 plans offer what are referred to as “age-based” funds that follow a set glide path that makes the account more conservative over time. Just select the age-based fund that corresponds to the first year the beneficiary plans to go to school and the fund will take care of the rest.
529 plans also place restrictions on how many times a year you can change the investments inside the account — typically capped at two — which is another reason why selecting an age-based investment that gradually reduces risk over time is preferable. These restrictions make a strong case for self-managing your 529 plan. Why pay someone a management fee if they can only make two moves a year? Instead, we recommend working collaboratively with a financial advisor operating under the fiduciary standard to advise on which 529 plan, and funds within that plan, may be right for you. In this type of arrangement you would open, fund, and manage the 529 plan on your own, but your financial advisor would be helping you each step of the way.
Here are some lesser-known strategies that high-net-worth investors should consider as they invest in a 529 plan.
The IRS allows you to save up to five times the annual exclusion amount — $15,000 — into a 529 plan in one year, without tapping into your lifetime estate tax exemption of $11.7 million. That means a married couple can contribute $150,000 total into a 529 plan in one year without triggering gift taxes. If you are thinking about implementing this type of strategy we recommend running it by your CPA first. The IRS treats five-year “superfunding” as if you gave $15,000 per year for the next five consecutive years so you will not be able to give any additional money to the beneficiary during that time without gift-tax consequences; meanwhile, the 529 plan enjoys tax-deferred growth on the entire $150,000 during the full five-year period. If you superfund a 529 plan when your child is young enough, and the markets perform favorably, you may never have to contribute to the 529 plan again.
Thanks to the 2017 Tax Cuts and Jobs Act, you can now use 529 plans to pay for up to $10,000 per student per year for private, public, or religious elementary, middle, and high school tuition. It is important to note that not all states have agreed to these new rules so you should check if your state complies or not, otherwise you may face unintended taxes and penalties.
If a grandparent is considering opening a 529 plan for the benefit of a grandchild, instead of the opening the 529 plan themselves, have the grandchild’s parents open the account and have the grandparent gift them money for contributions. A 529 plan owned by a parent affects a student’s financial aid eligibility differently than one owned by grandparent. In the eyes of the FAFSA form, which is used to determine a student’s financial aid, a parent-owned 529 is an asset to the student while a grandparent 529 plan is not. But a distribution to the student from a grandparent-owned 529 plan is considered income to the student, and income is more damaging on the FAFSA than owning an asset and drawing from it. Secondly, if a grandparent wants to help pay for college and only has a fixed amount to give — say $10,000 or $20,000 — it is better to give money to the student during their junior or senior year of college, than during their freshmen or sophomore year. The FAFSA form uses a two-year look-back when calculating student income so distributions received from grandparent-owned 529’s during their last two years of college will not show up on the form. The Senate is currently working on legislation that would alter the FAFSA form and remove these hurdles, but that has yet to become law.
Although not directly related to 529 plans, merit-based scholarships are another resource high-net-worth investors can take advantage of if they earn too much money to qualify for need-based financial aid. Merit-based scholarships do not look at balance sheets, taxes, or have income phaseouts, they only review a student’s scholastic and other achievements. If the beneficiary does receive a scholarship, you can take non-qualified withdrawals from the 529 plan up to the amount of the scholarship without paying the 10% penalty, but you still have to pay income tax on the earnings.
As a parent, it is important to provide opportunities for your children to learn about and build credit. Even if you plan on paying for college in full, you may want to consider having your children apply for student loans and then gift them the money for the loan payments. This helps them establish a credit history early in life, plus allows you to demonstrate disciplined spending habits before they go off to college and start buying Pelotons and Coachella tickets.
Many investors open 529 plans as a direct response to the unprecedented rise in tuition costs across the country. Others open 529 plans because they recognize how higher education opens doors to future income and opportunities for their children. Why stop there? Why not provide a lasting legacy of educational support for nieces, nephews, and future generations? In addition to being excellent college savings accounts, 529 plans have unique qualities making them shrewd estate planning vehicles. There are no annual contribution limits, no income limits on contributions, no age limits on withdrawals, and you can change the beneficiary almost at will, although certain changes may trigger tax implications.
The practice of using a 529 plan for estate planning purposes is commonly referred to as a “Dynasty 529 Plan” and is predicated on the fact that there is no limit on how many 529 plans you can open, in most cases. The beneficiary of the 529 plan can be changed to any family member without penalty, and, you can even change the owner of a 529 plan.
For the most part, 529 distributions used for family members avoid any taxes or penalties. The IRS’s definition of “family member” includes your spouse, child, spouse of such child, brother, sister, stepbrother, parent, grandparent, niece, nephew, aunt, uncle, son-in-law, daughter-in-law, and first cousin. However, if the beneficiary is a family member that is more than one generation younger, it will trigger Generation-Skipping Transfer Tax (or GSTT) which is an additional tax on transfers to generations two levels below you. Selecting a non-family member to be the beneficiary is treated as a distribution and the earnings in the account are taxed as income and charged a 10% penalty.
So you might be thinking, “If I get dinged because I name a beneficiary two generations below me, what is stopping me from making my child the owner, and then they turn around and name the same beneficiary, who is now only one generation below them?” There is no clear-cut answer, and it depends on the rules of each 529 plan.
A major estate benefit is that contributions to a 529 plan are considered completed gifts and thus reduce your taxable estate, but you still maintain some form of control over the money. Typically, when you remove an asset from your taxable estate, like placing it inside an irrevocable trust, you completely relinquish control over the asset. 529s work differently. Even though the money leaves your estate, you still can determine how the account is invested and who will receive the benefit.
Furthermore, the annual gift tax exclusion allows you to give $15,000 per year to as many people as you want free from federal gift taxes. Therefore, you can save for future education costs by putting $15,000 every year into a 529 plan and reduce your taxable estate. Or you could superfund the 529 plan with $75,000, — five years’ worth of annual exclusions — free of taxes. Suppose you are married and have 4 grandchildren, together you and your spouse could move $600,000 outside your estate by superfunding four separate 529 plans, one for each grandchild. Then, five years later, you can superfund them again. Note that the 5-year election must be reported on Form 709 for each of the next five years, but your lifetime exemption amount remains untouched. Also, if you use the five-year averaging election but die before the five years are up, a prorated portion of the contribution will be considered part of your taxable estate.
529 plans are often thought of solely as vehicles to help parents save for college, but they can also be excellent estate planning strategies. And there are creative ways to fund set them up and fund them that can take maximum advantage of the benefit of tax-free growth. Including them as part of your financial plan makes good sense.
Stratos Private Wealth is a division through which Stratos Wealth Partners, Ltd. markets wealth management services. Investment advisory services offered through Stratos Wealth Partners, Ltd., a registered investment adviser. Stratos Wealth Partners and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only; and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision. Investing involves risk including possible loss of principal. Some of the information contained herein has been obtained from third party sources which are reasonably believed to be reliable, but we cannot guarantee its accuracy or completeness. The information should not be regarded as a complete analysis of the subjects discussed.