Most people are familiar with or at least have heard of 529 plans. This blog is not a pro and con analysis of them. There are tons of free resources online to help you learn the basics. This week, I would like to share with you something you may not know about 529 plans.
1. Savings Plans VS Prepaid Plans
When it comes to 529 plans, people are mostly talking about 529 savings plans which work like your 401k plans by contributing and investing your money in mutual funds. Your account value will depend on the performance of the investment you choose in the plan.
However, there is another type of 529 plans called prepaid tuition plans. As the name indicated, it allows you pre-pay all or part of the tuition of an eligible educational institution at today's price without worrying about any price increase in the future. Unfortunately, there are only a few of them still open to new investment, the rest of them are either no longer accepting new money or closed permanently, mainly because it is harder and harder for funding the plan due to the skyrocketing tuition costs. State-sponsored prepaid tuition plans usually have a lot of limitations and may not be the best choice based on your specific situation. On the other hand, the Private College 529 Plan, the only plan not sponsored by a state but directly offered by educational institutions, may be an option worth considering. It allows you to buy "tuition certificates" at current rates which can be used at nearly 300 participating private colleges and universities in the U.S. including top schools like Stanford and Princeton.
In my opinion, 529 savings plans are still the best college saving vehicle for most people overall. The points mentioned below are also for 529 savings plans unless explicitly indicating otherwise.
2. Direct-sold plans VS Broker-sold plans
529 savings plans are either sold directly or through a broker. If you have read my previous blog post here before, you would know that I am not a big fan of brokers who are not required to put clients' interest on top of their own. It is always hard to know whether the products they recommend or the advice they give are affected by how much commissions they can get.
For most people, I think the direct-sold plans are the way to go as they are usually associated with a more transparent fee structure and lower overall expenses. If you need some professional help, you can go to someone who charges for their time and expertise but not to a commission-based salesperson.
3. You are not limited to the colleges and universities in your state.
The money in your 529 savings plans can be used at any eligible educational institution across the U.S. and even in some foreign countries. The IRS used to define an eligible educational institution as an eligible postsecondary school which includes any accredited public, nonprofit or proprietary college, university, vocational school, or other postsecondary educational institutions eligible to participate in a student aid program administered by the U.S. Department of Education. The new tax reform also adds eligible elementary or secondary school to it, including any public, private, or religious school that provides elementary or secondary education (kindergarten through grade 12).
It is always the best way to ask a school directly and check out whether it is an eligible educational institution or not. For eligible postsecondary schools, you could also use the tool here from Savingforcollege.com or check the U.S. Federal Student Aid Code List.
Out of curiosity, I found only two universities in China on the list i.e. the Chinese University of Hong Kong and Hong Kong University of Science and Technology.
4. You are not limited to the plan offered by your state.
All states besides Washington and Wyoming have their own 529 savings plans, some of them even have multiple plans. You are usually recommended to take a look at the plan in your state first and see whether it provides any benefits to you as a resident, especially tax benefits. If it does, the tax benefits may outweigh other factors including but not limited to investment options, fees and expenses, and customer services, and you should probably contribute to it first. You could find out what your potential tax savings would be by using the Vanguard 529 State Tax Deduction Calculator.
However, you are always free to choose other states' plans. For example, if the plan in your state does not offer any tax incentives to residents or the incentives are minimal compared to other factors, I would definitely recommend you shop around. You could use the tool from Savingforcollege.com to compare different plans. Even though your state's plan does have great tax benefits for residents, if you don't like other things it offers, you could consider contributing additional money to a second plan after taking full advantage of the tax benefits. And yes, it is a correct understanding that you can have more than one plan for the same beneficiary.
Besides, Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania offer a tax break to their residents no matter which state's plan one chooses.
5. Qualified education expenses are not limited to tuition and fees.
According to the IRS publication 970, qualified education expenses include qualified higher education expenses and qualified elementary and secondary education expenses starting in 2018.
Besides tuition and fees, qualified higher education expenses may also include books, supplies, computers, and software if they are either required or used primarily for the study. Expenses for room and board are also qualified to a certain extent as long as they are incurred by students enrolled at least half-time.
6. You won't lose all your money if your child receives tax-free scholarships or doesn't even go to college.
First and foremost, there is no income tax consequence at all if you change the beneficiary of a 529 plan to a member of the beneficiary's family including the beneficiary's spouse, children, brothers, sisters, parents, in-laws, and other relatives which you could find in IRS publication 970.
Second of all, you only pay taxes and the 10% penalty on earnings not on principals when you take out money for non-qualified education expenses.
Last but not least, the 10% penalty will be waived if the payment is included in income due to tax-free scholarship, fellowship grants, or even employer-provided educational assistance. There are some other exceptions to the penalty which you could also find in the IRS Publication 970.
7. You could supercharge your 529 plan without gift tax consequence
Contributions to a 529 plan are treated as gifts to the designated beneficiary. Under gift tax law, you are allowed to gift the annual exclusion amount ($18, 000 in 2018) to anyone before counting the applicable exclusion amount ($11,180,000 in 2018) for gift taxes. Also, there is a special five-year election you could make to contribute maximum worth of five years annual exclusion amount to 529 plan in a lump sum. It is a great way to jump-start a 529 plan. One caveat here is that, unlike gifting under annual exclusion amount, in order to benefit from this special treatment, you do need to file Form 709 and make an election even if you will not contribute more than $90,000 to a 529 plan in 2018.
8. The impact on financial aid may be not as severe as you think.
It is true that the money in a 529 plan will affect your need-based financial aid if your adjusted gross income is over $50,000. However, a parent-owned or a dependent student owned 529 plan is reported as parents' asset on Free Application for Federal Student Aid (FAFSA®). Only 5.64% of the money in the plan will be counted in the worst case scenario when calculating the Expected Family Contribution (EFC). In other words, if you have $10,000 saved in a 529 plan, the financial aid your child would have received will be reduced by $564 at most.
Watch out for 529 plans owned by people other than the student or parents, such as grandparents. The money in the plan will not be reported as an asset when calculating the EFC for the current year. However, the distributions will be counted as untaxed income to the student which could affect the need-based financial aid eligibility dramatically on the subsequent year's FAFSA. It may make sense to use the money in those accounts during the last year of college to avoid the negative consequences based on your specific situation.
After going through all the concepts above, I hope you have a better understanding of 529 plans now. As always, I am pleased if you can learn one thing only or at least one useful tool from this post.
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