My wife and I were talking at the dinner table last night about how much the cost of one year of college tuition would be in the year 2036. The year 2036 holds a special place in our heart, as it is the year that our three-month old son will (potentially) be leaving the nest for four (or more) years at an educational institution to prepare him for the “real world.” The numbers we were throwing around were so large they seemed laughable, but they may become reality in eighteen short years. Although the potential cost of college seems daunting for almost everyone, there is some help available for parents (or grandparents, aunts, uncles, or really anyone) that want to set aside money to be used for future education expenses. Some of that helps comes by the way of a 529 Plan.
WHAT IS A 529 PLAN?
If you already know what a 529 Plan is, congratulations! You are in the minority, as less than one-third of all Americans know that a 529 Plan is an education savings vehicle according to a 2017 Edward Jones survey.
What are the benefits?
Tax Savings: Money in a 529 Plan grows tax-free and is not taxed when distributed from the Plan to pay for qualified education expenses. When compared with a traditional brokerage account, the 529 Plan provides a significantly better option from a tax standpoint. When the brokerage account is liquidated, tax is owed on the realized capital gains, which is in addition to the tax that was paid on all dividend and interest income throughout the life of the investment. With a 529 Plan, there is no tax due on the capital gains when the investments are sold to pay tuition/expenses and any dividend and interest income is also sheltered from income tax while the investment is held in the Plan. Although there is no federal tax deduction for the contributions, many states offer deductions for contributions to a 529 Plan. For example, New York State allows for a deduction up to $10,000 for married taxpayers.
Outside of the tax savings, the 529 Plan boasts these other benefits:
- Contributions can be withdrawn at any time without penalty as they are contributed with after-tax money (states may require income to be recaptured if a deduction was taken on your state income tax return).
- Contributions can be made by anyone (grandparent, aunt, uncle, friend, etc) and the owner of the account remains in control.
- The account is often very low maintenance and you can set up automatic contributions to help in consistent savings. You are essentially able to set it, forget it, and watch the money pile up in the Plan.
- You are not precluded from making 529 Plans if you are a high-earner. There is no income limit for 529 Plans, as there is for an account such as a Roth IRA, where contributions are not allowed if your income is over $199,000.
What are the drawbacks?
As with any investment, there is always risk that the investment value will decline. Over a long time horizon and with adequate diversification, this downside risk can be mitigated. The major drawback comes in the case that funds are withdrawn and not used for education expenses. This results in tax due on any gains realized plus a 10% penalty. It could be the case that the beneficiary of the 529 Plan does not end up needing the funds for education expenses. However, if the beneficiary does not need the funds because he/she received a full scholarship, the amount withdrawn from the Plan equal to the value scholarship is not subject to a 10% penalty. Additionally, the 529 Plan can be transferred to another beneficiary and retained its tax-favored status.
How are 529 Plans affected by the Tax Cuts & Jobs Act?
Prior to the Tax Cuts & Jobs Act, the use of 529 Plans was restricted to postsecondary education tuition and expenses. The TCJA will allow for $10,000 per year to be withdrawn to pay for elementary and secondary education expenses as well, beginning in 2018.
Similar to saving for retirement, earlier is better when beginning to save for future education expenses. Adhering to a consistent strategy to contribute to savings vehicle such as a 529 Plan, will perhaps allow you to rest a little easier despite the anticipation of the future price tag of a college education. I have heard of 529 Plan-themed birthday parties, where a contribution to the child’s 529 Plan is made in lieu of a gift. I think I am going to have to sell my family and friends on that idea for Junior’s first birthday!
