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Give the Gift of Higher Education with a Section 529 Plan
Nancy B. Crowley, CPA
As the holiday season approaches, you may want to forgo giving the latest electronic device and give your children and grandchildren the gift of higher education instead.
College costs continue to climb and exceed inflation. According to The College Board, the average total annual cost of out-of-state tuition, fees, and room and board is $35,370 for a public four-year college, a 2.7% increase from the prior year. The average total annual cost of tuition, fees, and room and board is $45,370 for a private nonprofit four-year college, a 3.4% increase from the prior year.
On the highest end of the college expense spectrum, the top ten most expensive U.S. colleges and universities for the 2016-2017 academic year had total annual costs ranging from $66,000 to $69,700, before any financial aid awards.
Based on these costs, coupled with annual increases, it is important to plan early for college. One very effective way to save for college is by setting up and contributing to a Section 529 Plan, also known as a college savings plan.
What is a Section 529 Plan?
Section 529 Plans are tax advantaged “qualified tuition programs”. There are two basic types of Section 529 Plans, one is a Savings Plan and the other is a Prepaid Tuition Plan.
The Savings Plan is established and maintained by a state, a state agency, or instrumentality. Contributions are made into an account for the sole purpose of meeting qualified higher education expenses. The earnings in the plan grow tax free provided that the withdrawals are used for qualified education expenses.
Prepaid Tuition Plan is established and maintained by an eligible educational institution. Tuition credits or certificates are purchased which in effect are prepayments of tuition expenses locking in that year’s current tuition costs to avoid future increases in tuition.
Who are the participants in a Section 529 Plan?
There are two primary participants associated with a Section 529 Plan. Each Section 529 Plan has an account owner. The account owner opens the account, makes contributions to the plan, chooses an investment portfolio, requests withdrawals, and has the authority to change the beneficiary. The other participant is the beneficiary, the person for whom the custodian establishes a Section 529 plan and most likely is the person who will use the accumulated funds to further his or her education.
Anybody can set up a Section 529 Plan and designate a beneficiary. There is no limit on the number of Section 529 Plans that a person can set up. Each plan should have only one custodian and one beneficiary. Although the owner/custodian sets up the plan, anyone may contribute to an already established Section 529 account. For example, if a parent/custodian establishes a 529 plan for her daughter, the grandparents may also contribute to the plan.
How does a Section 529 Plan work?
All 50 states and the District of Columbia sponsor at least one type of Section 529 plan. You can invest in any state’s plan. Over 30 states, including the District of Columbia, offer full or partial state deductions for contributions to a Section 529 Plan. In Massachusetts, 2017 is the first year that the Commonwealth provides an income tax deduction of up to $1,000 per year for an individual and $2,000 per year for a married couple who contribute to a 529 Plan.
Once a Section 529 Plan account has been opened, contributions may be made to the plan. Each plan has a minimum contribution to open the plan and a maximum over time contribution limit ($375,000 in Massachusetts).
A contribution to a Section 529 Plan is considered a gift for tax purposes. In 2017, any individual may make an annual gift to a Section 529 Plan of up to $14,000 (increasing to $15,000 in 2018), per beneficiary, and not be subject to gift tax. A married couple may make a joint $28,000 (increasing to $30,000 in 2018) annual gift to a Section 529 Plan and not be subject to gift tax. In addition, there is a special provision, unique to Section 529 Plans, which allows an individual to fund a Section 529 Plan with a maximum amount of $70,000 in one year, an amount equal to five times the federal annual gift tax exclusion. Similarly, a married couple may make a maximum joint $140,000 gift in one year, an amount equal to five times the joint federal annual gift tax exclusion. In 2018, these figures increase to $75,000 for individuals and $150,000 for married couples jointly making the gift. By front-loading the Section 529 Plan with $70,000 ($140,000 if married and jointly making the gift), the donor may not make any other gifts to the 529 Plan beneficiary during the five-year period without incurring a gift tax liability.
Once the Section 529 Plan has been funded, the owner/custodian chooses an investment plan. Options may include age-based portfolios or static portfolios. An age-based portfolio adjusts with the child’s age by becoming more conservative the closer the need for the funds. A static portfolio remains the same over the life of the plan. As a Section 529 Plan custodian, you should consider your risk tolerance, the age of the beneficiary, as well as the fees and expenses associated with the investment options.
Withdrawals from a Section 529 Plan are tax free to the extent that the beneficiary uses the funds for qualified higher education expenses. These expenses include:
- Computers and related equipment
- Room and board
Section 529 funds may not be used for:
- Insurance, sports, club fees or any other fees charged that are not a requirement of enrollment
- Transportation costs
- Repayment of student loans
- Room and board more than the amount charged by the school
It is very important to note that higher education includes two-year, four-year and graduate schools, as well as vocational schools or other postsecondary educational institutions that are eligible to participate in a student aid program administered by the U.S. Department of Education.
Should the beneficiary decide not to pursue higher education, there are still options. The account owner/custodian may change the Section 529 Plan beneficiary to a sibling or other qualifying family member, or the account owner/custodian may use the funds for his or her own continuing education, or the funds may be set aside for a grandchild. Lastly, if none of those options are practical, the account owner may take a non-qualified withdrawal, pay the income tax and a 10 percent penalty on the earnings portion of the withdrawal (only the earnings are taxed as the contributions were made with after-tax money).
There are a few disadvantages to a Section 529 Plan. A Section 529 Plan, with a parent custodian, will be considered a parental asset for financial aid purposes. When determining financial aid, 5.64% of parental assets are factored into the student’s financial aid eligibility. If the grandparent owns the Section 529 Plan, any distribution will be valued at 50% and included as student income for purposes of determining financial aid in the following year. Other disadvantages are that investment holdings may be changed a maximum of two times per year and only one tax-free rollover from one Section 529 Plan to another is allowed in a 12-month period.
Overall, we consider Section 529 Plans a very smart way to save for the cost of child’s college education. If you have any questions or need help in evaluating a Section 529 Plan for your family’s specific situation, please contact your RINET relationship advisor.