Before 1996 there wasn’t really an official way for parents and grandparents to save for the next generation’s possible college costs. There wasn’t anything stopping people from saving. There were even accounts created by the IRS code that seemed helpful to use, like Educations Savings Accounts (ESA) or Uniform Transfer to Minor’s Accounts (UTMA) and even cash value life insurance. But none of those really seemed effective enough, so congress created the 529 plan. This has since become the first option most families and advisors consider when setting up an account with the goal of saving for college costs, amassing over $247 Billion as of 2014 according to CollegeBoard.org1, and much more since then surely. Has this solved the problem? Are households able to set aside money, using the tax advantages provided by these plans, at a rate that allows young students the opportunity to attend college without large loan burdens upon their graduation? $247 Billion sounds like a lot of money, and it is, but the answer is no not exactly. It has helped, but a variety of features about these plans and the way they were set up has resulted in questions and possibly hesitation in family’s minds when considering whether or how much to fund them. In other words, I’m taking the popular route and blaming congress. Listed below are a few of those most commonly asked questions, their answers, and possibly some planning you can implement around the answers.
What if my child wants to go to college out of state? When 529 plans first came out for some reason it was decided that states, and even individual colleges, would have the authority over plans set up in their state. This immediately created the assumption, rightly so, that exists to this day that if you deposit money into an account and your child happens to want to go to college at any one of hundreds of colleges outside that state, or even if you thought you might personally move out of state, that it would be disadvantageous to fund one of these plans. This is not the case however. The beneficiary of the plan, the student, can use the money in the account to pay for tuition and other costs anywhere in the country and many schools internationally, no matter what state you are in when you fund the plan, which state’s plan you use, or if you move during the process2. What is the advantage or reason for using an instate plan then? There are certain small tax advantages which are discussed in the FAQs further along in this article, however it’s possible all the state specific nature of 529 plans has done is diminished contribution rates due to misunderstanding.
What happens if they receive a scholarship? This is asked far more often than is the likelihood of earning a full scholarship, given how few of them are awarded. However, it certainly is a possibility that parents could find themselves over funding a 529 plan if it turns out their child is doing well and is offered assistance. There could be other reasons parents feel they are making a smart decision to carefully not overfund the plan, like other ancillary costs of attending school, the possibility of the investments in the plan doing very well, or the child choosing a school on the lower end of tuition costs. What happens to the money? The answer is that the money, in most situations, can be used for ancillary expenses. Which makes fully funding the 529 a good idea, but for people hearing about these plans for the goal of covering tuition, there is the connotation one has to put all this money in and still come out of pocket for housing, transportation, food, books, and seemingly endless trips to Target. The rules do say though that the money can used for room and board, and an equivalent amount if living off campus. Similarly, it can be used for the cost of food, for books and computers. No luck on the Target trips.
Do I receive any tax benefits for contributing to a plan? Yes, there are tax advantages to using 529 college savings plans over investing outside one. Seeking out a tax advisor and exploring the specific rules on the IRS website is a good idea here, but provided those are followed the money in these plans does not incur tax when withdrawn for qualifying education expenses. This means if you put in a certain amount of money and it grows to a larger amount by the time the children reach college, that gain isn’t taxed. It would normally be taxed at the capital gains rate and you would also have taxable income if you invested in anything that produced it, like bonds. Deposits are made after tax, meaning there is no federal tax deduction for utilizing these plans. Said another way; you have go out and earn the money you are depositing to these accounts, pay tax on those earnings, and then choose to help your children attend college down the road instead of spending the money on more fun things like going out to dinner. Perhaps another reason people choose not to fully save to the 529 plans is the competing goals of saving for retirement and home buying offer more immediate tax breaks. The states have stepped in, and provided you use the correct plans, offer a deduction up to certain levels off your state income tax return. Any deduction is helpful however you might find the actual dollar amount of savings here isn’t that substantial.
Can I use the money to pay off student loans? At first this might seem like a curious question, if the money in the 529 exists why take a loan in the first place? This comes up more often than you might think. The biggest reason saving for college is so overwhelming is really that you only have a very short time period to accomplish the goal. Kids go to college at 18 give or take. Let’s say you wait until they are 2 or 3 before realizing if little Johnny or Julie can figure out how to walk maybe they will be college bound after all. That gives you about 15 of the quickest years of your life to accumulate what could end up needing to be hundreds of thousands of dollars. And that’s per child! On the other hand, by the time they start getting near college age perhaps your income is higher as your own career has grown and you could really afford to save some money to the plans. By then though you just have to give it right to the colleges. Some parents conclude it would be nice to get some state tax deductions on these deposits, let the investments work for them if the markets are cooperating, and enjoy the tax-free growth. Let the child take on some school loans to have some skin in the game and work with them to pay those loans off over time with the 529 money. But that’s not allowed. Distributions from 529 plans can not be used to pay for student loans, at least not with the money coming out of the 529 tax free. In January 2017 there was a bill in Congress to allow for this but it hasn’t made any progress since.
What happens if they don’t go to college? Similar to the question about receiving a scholarship, what if the child doesn’t end up going to college? In the scholarship scenario there are a wide variety of related costs that the 529 can be used for. If they don’t go to college at all what happens to the money? If they really don’t obtain any higher education learning parents can change the beneficiary to another child, or just cash in the money causing the tax obligations. What’s more likely perhaps is the reason they aren’t attending traditional college is because they are obtaining specialized training in a chosen field that still costs money and still needs financial support. 529 plans still work in many of these scenarios. The official answer from the IRS of where the money can be used is: An eligible educational institution is generally any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education3.
In conclusion, if you are reading this don’t get discouraged, save what you can, work with your child to have the best academic career they can, and you will be ahead of the game. Saving money helps by providing options when the time comes. What the future holds isn’t clear, but it will probably be expensive.
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Brian Kuhn CFP® is a financial planner with Planning Solutions Group. If you would like to discuss this or any personal finance topic he offers online scheduling at www.psgclarity.com or email Brian at firstname.lastname@example.org
2 & 3 https://www.irs.gov/uac/529-plans-questions-and-answers