College Savings Account Primer
Nowadays, the 529 plan is ubiquitous among those families with children planning on or going to college. The advantages are obvious – tax-deferred growth of savings, potential tax-free distributions, and often a state tax deduction for the investor. That much is simple and straightforward; but as they say, “the devil is in the details,” especially when the details continue to evolve. Some questions we often get are: How much can I contribute? How should I invest my contributions? What if my child does not attend college? What if we move from one state to another? Does it matter that my child plans on attending an out-of-state school? What education costs are considered qualified? What seems straightforward can get a bit tricky without good advice. So, let’s break down the 529 savings plan, shall we?
The predecessor of the 529 savings plan was the Michigan Education Trust (MET), created in 1986 to provide Michigan residents with a pre-paid college tuition savings plan. In 1996, Section 529 was added to the Internal Revenue Code, bringing the education savings plan into existence. In its current structure, a state may potentially offer three different variations of the 529 plan: a state-run pre-paid tuition plan, a state-run investment savings plan, and a state-sponsored advisor-run investment savings plan. Through its evolution, it turns out the investment savings plan is now a more popular version than the original pre-paid tuition savings plan for a variety of reasons. Advantages include the ability to cover a larger menu of costs, greater flexibility in investment management, and wider applicability across the country. In fact, currently, there are only twelve states that offer pre-paid tuition plans.
Beyond the pre-paid tuition savings plan, states may offer 529 plans that are either direct-sold or sold through an advisor. Some states offer only direct-sold plans, including California, Washington, D.C., and Massachusetts, while others offer both. In addition to different options for state sponsored college savings vehicles, each state may have varying levels of tax benefits. In states like Florida and Texas, where there is no state income tax, the 529 account holder may have greater freedom to select any 529 plan across the country. A select few states that levy state income tax do not allow for any deduction against 529 contributions, including California, New Jersey, and North Carolina. Most other states with a state income tax carry income tax advantages. Some other states allow tax deductibility for 529 contributions regardless of whether the investor chooses their own state-sponsored plan. Therefore, understanding the specific rules of your state’s 529 plan is advisable.
On the federal level, there are some consistent features including maximum annual gifting amounts, portability across beneficiaries, and limited investment trading. As an example, each plan owner can contribute up to $17,000 in 2023 free of gift tax, per beneficiary, or front load up to five years’ worth of gift contributions, also free of gift tax. A married couple with two children can establish up to four 529 accounts – Dad 529 FBO Child 1, Mom 529 FBO Child 1, Dad 529 FBO Child 2, Mom 529 Child 2 – and contribute $17,000 per year in each, or up to $85,000 in each as long as they do not contribute again for the next five years. If one child ends up not attending college or leaves a surplus, those funds can be transferred to a sibling’s 529 account.
In recent years, Congress has expanded 529 rules to allow even greater flexibility and applicability for families. Newer rules allow distributions from 529 plans for K-12 schooling, paying student loans, and now funding Roth IRA contributions for beneficiaries. The stipulation for the first two rule changes is straightforward: a max of $10,000 per year per student can be used to pay for K-12 schooling and a one-time max of $10,000 per student can be used to pay down student loans. The Roth IRA funding option is a bit more complex. The maximum allowable funding from 529 to Roth IRA is $35,000, subject to annual regular Roth IRA contribution limits (currently $6,500) and must match earned income from the beneficiary. Further, the 529 plan must have been in existence in its current form for a minimum of 15 years, including the same owner, same designated beneficiary, and same state plan. Lastly, the amount transferred must have been in the 529 plan for at least five years. So, if the account owner moved states and thus moved state 529 plans or transferred funds among beneficiaries, there may be challenges to the Roth conversion option.
For these reasons, we suggest everyone read the fine print and fully understand all terms of 529 plans to avoid finding yourself in a precarious tax situation years after the fact.
Meet Angel Irazola »
Read the November 2023 Financial Planning Focus:
- “Don't Look Now But 2024 is Just Around the Corner” By Brian Horan, CPWA® »
- “Financial Planning 101 – Debt Management” By Matt Armendaris »
- "Want a $2 Million IRA in 10 Years?" By Matt Cohen, CFP®, CIMA® »
West Financial Services, Inc. ("WFS") offers investment advisory services and is registered with the U.S. Securities and Exchange Commission ("SEC"). SEC registration does not constitute an endorsement of the firm by the SEC nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by WFS, including Form ADV Part 1A, Part 2A brochure and all supplements, and Form CRS.
Certain information contained herein was derived from third party sources, as indicated, and has not been independently verified. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. Where such sources include opinions and projections, such opinions and projections should be ascribed only to the applicable third party source and not to WFS.
This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product, security, or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. You should not treat these materials as advice in relation to legal, taxation, or investment matters. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisers.