By: Andrew Rosen, CFP®, CEP®

With the recent birth of my 3rd child, I figured I’d write about one of my biggest concerns these days – saving for college.  Many of our clients with children, or grandchildren, are having the same concern.  I think it is important to understand the benefits of utilizing a 529 plan to pay for college.  (I should preface that this article isn’t meant to sway my kid’s Grammy into funding their 529 plans! But hey, unintended consequences aren’t always bad!)

What is a 529 Plan?

A 529 Plan is a way to save for college on a tax favored basis.  There are two types of 529’s. The first is a prepaid tuition plan.  The second is a college savings plan.  I don’t see much value in the prepaid plans.  Therefore, for this article I’ll only be referencing the more common college savings plans.

These plans have a basic structure. You contribute after-tax dollars and your money is invested in mutual funds. The dollars then grow tax sheltered.  If used for higher education, all of their growth is tax free.  These plans are a terrific mechanism for both parents and grandparents as a way to save for college.

Every state offers their own mutual fund sponsored plan; however, there are no requirements as to which plan you must use or what college the child must attend.  Some states offer a state deduction if you use their plan.  But at the end of the day, it’s simply a preference on the underlying mutual fund company you care to use.

What can a 529 pay for?

529’s can pay for a variety of post-secondary expenses.  Tuition, room, meal plans, and books all fall into the category of allowed expenses.  However, it is always best to check the IRS site to see what is officially allowable.  Also, you must receive the funds the same year in which the expense occurred.

Who can use the funds?

Flexibility is one of the best features of a 529 plan.  The owner of the plan can change the recipient (or beneficiary) to any blood relative of the original beneficiary.  This means if a child doesn’t attend college, or receives a full ride, you can reallocate those dollars to their sibling or cousin fairly seamlessly.

What are the funding limits?

There aren’t really funding limits when it comes to 529 contributions at the federal level.  Each state has an amount that once exceeded prohibits further contributions.  But, that is almost never an issue as these limits are quite generous.  For instance, New York’s limit is $375,000 which is rare for us to even see that much in one person’s account.

Since contributions to a 529 for a child or grandchild constitute a gift, there should be some consideration given to the gift tax exclusion.  Currently any person can give $14,000 to any other non-spouse without eating into one’s lifetime gift tax.  Married couples get to double this amount to $28,000 since they each get an exclusion.  One of the unique provision with a 529 plan is it allows you to contribute 5 years of gift tax exclusion upfront without triggering a gift tax issue (i.e. $70,000/person upfront in 2017).

What is the penalty if you don’t use all the funds?

First, there isn’t really a time limit to use these funds.  Put simply, you can easily make the original beneficiary’s children, or sibling’s children, the recipient.  This can give you 40 plus years to worry about withdrawing the funds and one heck of a generous future gift (with the power of compounding).

If there are funds left over, and you do want to pull them out, you would pay ordinary income tax and a 10% penalty on the growth of these funds.  As an example, if you contributed $100,000 and it grew to $150,000, you’d pay the 10% penalty on the $50,000 (plus ordinary income tax on that same amount).

A final note on the 10% penalty provision.  If your child/grandchild receives a scholarship you may take the scholarship equivalent amount out of the 529 plan without penalty.  You would still owe the capital gains on any growth, like any non-retirement investment, but you would avoid the 10% penalty.  For instance, if your child received $10,000 of scholarship funds their freshmen year one could pull $10,000 out of the 529 without incurring the 10% penalty.

Will a 529 impact student aid?

Short answer, yes.  Any assets owned by the parent (or child) are used in calculating expected family contribution.  The FASFA formula will assess a lower expected contribution rate to parent assets (5.64% for parental assets vs. 20% for the student’s assets).  529 plans, assuming owned by a parent, are assessed at the lower 5.64%.  In most cases, the funds set aside for college will be in the parent’s name already. Therefore, there is no additional negative impact to holding these assets in a 529 plan.

Things change slightly for a grandparent.  529 plans owned by a grandparent won’t factor in the financial aid calculation. However, when the funds are taken out to pay for college, they will count in the following year’s financial aid formula as untaxed income to the student.  This can reduce the amount of financial aid by up to 50%. Under these circumstances I recommend that families use the grandparent’s funds in the last year of college as to not negatively affect any aid.

What are you waiting for? Go tell Grammy!

As you can see there are very few negative impacts of a 529 plan.  In a world where college expenses are skyrocketing, every dollar helps.  So what are you waiting for?  Pick up the phone and let Grammy know the good news!

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Andrew Rosen

In his role as Financial Planner, Andrew forges lifelong relationships with clients.  He coaches them through all stages of life and guides them to better achieve their life goals.  For more information about Andrew or the other firm partners, Kyle Hill and David Levy, click the link below.

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