Ultimate guide to 529 college savings plans

Just do this: If you think you, or your children will attend some form of private / paid schooling in the future (private K-12 school, college, vocational programs), and you’ve maxed out your other tax-advantaged savings vehicles (401K, Roth etc.), then you should contribute to a 529 college savings account. The money will grow tax free, and can be used tax free if spent on qualified educational expenses (rent, tuition, books etc.). You can invest up to $520K in a given account, but you might not want to invest that all at once keeping in mind the impact of gift tax laws when making your contributions. Lastly, if your child doesn’t use all the funds, you can transfer between children with no impact, or even pass it down to grand-children (though with potential impacts on gifting / estate taxes). In the worst case scenario, you can take the money out of the account at which time any gains will be taxed at the federal and state level, with a 10% penalty from the federal government, which might not be so bad if you’re currently in a really high tax bracket, but expect to be in a lower one later in life.

Nine months ago my wife and I welcomed our first child into the world. With that arrival, came a whole slew of questions around how to save for the future. In particular, how to prepare for the cost of college education. There’s a completely legitimate debate as to what the state of higher education will even look like 18 years from now, but if you believe some version of college will remain a rite of passage for most, then it’s a good idea to start planning now. 529 savings accounts are one of the better ways to do this.

Using my 529 College Savings calculator, you can quickly see that the benefit of tax free gains and withdrawals can be significant. I compared a regular investment account with a 529 investment account, starting them each with $100K, and growing them for 20 years with capital gains and dividend reinvestment. What we see is that the regular account grows to $376K while the 529 grows to $456K. After accounting for taxes on the regular investment account, we find that the 529 account ends up with >$112K more money available for education (>30% more – $456K vs. $344K):

Screen Shot 2018-05-14 at 9.06.05 AM.png

What’s also interesting in this example is that if the plan owner decided not to use the funds for education, the amount they would have available after paying taxes and withdrawal penalties ends up being more than the regular investment account. This means even if they don’t use the funds for education, they could end up ahead. That’s a pretty good reason to think about saving for your child’s education.

How it works

In short, there are two options for college savings plans:

  • 529 Prepaid Tuition Plan (don’t do this) – Allows you to pay tuition for a specific school in advance, but leaves you locked into attending that school
  • 529 College Savings Plans – Contribute to a general savings account that can be used at any qualifying institution

I won’t even address the ‘prepaid’ option, because I just can’t imagine what sort of scenario would have you knowing 18 years in advance which school your child will get into, let alone want to go to. You’re better off focusing on the savings plan with the greatest set of options and flexibility.

The 529 College Savings Plan allows you to grow invested funds tax free almost indefinitely, and to withdraw those funds tax free when used for a qualifying educational expense. Those expenses include (source):

  • Tuition
  • Room and board
  • Mandatory fees
  • Books
  • Computers
  • Software (if required)

In addition, over 30 states allow for income tax deductions on the funds you contribute into the 529 account (details here), which makes the potential tax savings even more compelling.

So if you think this is for you, figure out if your state offers tax deductions. If they do, then choose an in-state plan (being mindful of fees!). Otherwise, feel free to peruse the various plans offered across the country and pick one that fits your criteria. If you’re not taking advantage of a state tax deduction, you can choose from the various other state plans that allow for non-residents to invest. For more on the best funds available, keep reading!

How much will you want to save?

So how much should you aim to save? Well, there’s a good college cost calculator that helps you think about this. In the extreme, four years at a private college in 2035 is expected to cost ~$525K. After adjusting for scholarships and grants, they suggest saving ~$380K if you plan for a private university:

Screen Shot 2018-03-09 at 11.56.51 AM.png

On the lower end this calculator recommends something in the range of $200K for and in-state public university. $300K sounds like a reasonable number to start.

How much can you contribute in total?

With a 529 College Savings Plan, each state sets a maximum contribution limit ranging from $235K-520K – once your account reaches that limit, you’ll no longer be able to add more funds, but the existing account can continue growing tax free almost indefinitely until you decide to withdraw.

How much can you contribute per year?

Generally speaking there are no limits to how much you can contribute in a given year. But you will want to consider the impact on your lifetime gift tax exclusion before you deposit a big chunk of change in a single year. Anything over the ‘gift tax exclusion’ will be counted toward your lifetime gift tax exclusion. As noted on savingforcollege.com:

Annual gift tax exclusion

One of the many benefits of saving for a child’s future college education with a 529 plan is that contributions are considered gifts for tax purposes. In 2018, gifts totaling up to $15,000 per individual will qualify for the annual exclusion. This means if you and your spouse have three grandchildren you can gift $90,000 without gift-tax consequences, since each child can receive $15,000 in gifts from you and $15,000 in gifts from your spouse. Remember, this also includes non-529 gifts so be sure to include any cash or property gifts in your total.

If your total gifts to an individual will be more than $15,000 this year, the excess amount will have to be reported on Form 709 when you file your taxes in 2019. There is no joint gift-tax return, so you and your spouse will each have to file separately.

The 5-year election

You may have read that you can contribute as much as $75,000 to a 529 plan without incurring gift taxes. This is absolutely true, as long as your contribution is at least $15,000 and you spread it over a five-year period. The amount will be pro-rated over the next five years, so if you deposit $50,000 it will be applied as $10,000 each year, leaving you with $5,000 in unused annual exclusion.

This is often a great estate-tax planning strategy for grandparents. They’re able to shelter a large amount of assets from estate taxes, while retaining control of the funds in the 529 account. However, if you do end up changing your mind down the road and revoking the funds in the account they will be added back to your taxable estate.

Lifetime gift exemption amount

Does this mean if you contribute more than $15,000 in one year or $75,000 over five years you’ll have to pay gift tax? Not necessarily. As mentioned above, any gifts above the annual exclusion amounts will have to be reported on the federal tax Form 709, and these will be counted against the lifetime exclusion (currently $11.2 million per individual in 2018). Any amounts that exceed the exclusion could trigger gift taxes of up to 40%, but if you’re within the limit you won’t be subject to taxes.

So, if you don’t expect to pass on ~$5M or more to your children, you probably don’t need to worry about the gift tax exclusion, but if your estate stands a chance of being larger than that, then you’ll really want to start ‘gifting’ to your children and grandchildren sooner by maximizing the annual exclusion every year (If you don’t know how much you might be worth in 20 or 30 years, check out the Ramen Retirement Lifetime Wealth Calculator). The best route, if you have the cash, is probably to max out the 5-year election every five years until the account contribution limit is reached. This lets you put down a big chunk of change in a single year, giving it more time to grow.

Which plan provider, and investment option to choose?

So you want to open a 529 plan. Where to start? If your state offers a tax deduction or credit for contributing to an in-state plan, then you should seriously consider taking that route. Sheltering that income upfront could be a big benefit depending on your current marginal tax rate, but if there’s no benefit to contributing to an in-state plan, then you’re free to shop around and find the most compelling plan from your own or other states – many state programs will allow non-residents to open accounts and invest.

A few things to keep in mind when choosing a provider:

  1. Minimize fees
  2. Maximize contribution limits
  3. Ensure good investment options

Once you’ve identified a state plan provider, you’ll want to review their investment options. Providers typically let you invest in ‘age based’ funds, or choose a static fund directly. The ‘age based’ funds will adjust your allocation between stocks and bonds over time – getting more ‘conservative’ with a greater share of bonds as you get closer to needing the money for educational purposes. If you know me, then you know I suggest avoiding bonds, and instead buying a broad based US or global equity index fund. Passive, low fee, all stock, no bonds. It’s that simple. Find a provider, then find the broad based, low fee index fund they provide – then compare across providers to see which one has the lowest fees, and highest maximum contribution limits. Below is the list of the top state plans and specific investment options I would recommend. Personally, I’m partial to the California and New York plans. They have the lowest fees, highest maximums and a good set of investment options managed by Vanguard and TIAA-CREF:

Screen Shot 2018-03-13 at 8.29.45 AM

(link here)

Minimize fees

You should be looking for a fund that has:

  • Absolutely no one-time sales or enrollment fees
  • No account maintenance
  • Little to no program management fees
  • Low (0.05-0.15%) investment management fees

All-in, total asset management fees should not be more than 0.2%, and can get as low as 0.09% for a good passive US stock index fund (See California’s ScholarShare US Large Cap Equity Fund).

Also, make sure to avoid any programs with sales commissions or up front one-time fees – as highlighted below on the Illinois Bright Directions Advisor Guided 529 Plan:

Screen Shot 2018-03-10 at 6.28.13 AM.png

Maximize contribution limits

As noted above, you’ll probably want to contribute $300K or more into this fund – therefore, you don’t want to get capped out by a maximum contribution limit. All the funds I recommend above have limits at or above $370K. California and New York have particularly high limits.

Ensure good investment options

As mentioned above, I am partial to low fee, passive, all-stock investment funds. But you might have different preferences, so check out the other options those plans provide. Generally speaking, they all provide age based plans, and a good set of static plans. California or New York should have everything you need.

Changing beneficiaries: What if your beneficiary doesn’t use all the funds?

We all know that life is unpredictable. It’s possible you won’t end up using everything you save for the primary beneficiary you choose. In those cases, you can change the beneficiary. There are two types of beneficiary change. The implications are important for each:

  1. Same family, same generation: Example: As a parent you can change the beneficiary from one of your children to another. Or from your child to one of their cousins. This will transfer over without incurring any additional gift taxes, or non-qualified distributions. No impact.
  2. Same family, different generation: Example: A grandparent can change the beneficiary from their child to their grandchild. This will transfer over without triggering a non-qualified distribution, but it will trigger an additional gift tax for one of either the original plan sponsor, or the original beneficiary. This could have an impact when it comes to estate planning.

As noted on fa-mag.com:

Changing the beneficiary can result in a gift-or worse. A 529 account owner can change the beneficiary without tax consequences if the new beneficiary is a member of the family of the old beneficiary and the new beneficiary is, for generation-skipping transfer tax purposes, assigned to the same generation as the old beneficiary. A “member of the family” is defined in Internal Revenue Code section 529, but includes, among others, siblings, descendants, parents and cousins.

Thus a parent can change the beneficiary from one child to another child and a grandparent can change the beneficiary from one grandchild to another grandchild without adverse tax consequences. If the new beneficiary is not a member of the family of the old beneficiary, the change will be treated as a non-qualified distribution and the earnings portion of the account will be subject to income tax and the 10% penalty. In addition, the IRS may treat the change of beneficiary as a new gift to an account for the new beneficiary.

If the new beneficiary is a member of the family of the old beneficiary but is in a later generation-for example, if the beneficiary is changed from a child to a grandchild-then the change is treated as a gift. The IRS is unclear at this point whether the gift is from the old beneficiary or from the account owner to the new beneficiary. Whoever is deemed to be making the gift could apply his or her gift-tax annual exclusions and even make the five-year election to mitigate the tax consequences of the gift.

What if you take some of the money out as a non-qualified withdrawal?

In the worst case scenario, if there are no other beneficiaries you wish to transfer the funds to, you can either keep the funds in there almost indefinitely (see below for more), or withdraw the funds as a non-qualified distribution. If you take a non-qualified distribution you will have to pay federal and state tax on any gains. In addition, you will incur a penalty of 10% on all gains from the federal government, and 2.5% if you’re a resident of California at the time.

This sounds punitive, but in reality it might not be so bad. If you contribute funds to the 529 plan during the peak of your earning years, it’s likely your marginal rate could be close to 50% or higher. If you wait until your retirement years to pull those funds out of the 529 plan, your marginal rate could easily have dropped to 15-20%. In that case, the added 10% federal penalty gets you closer to a 20-30% tax rate on your gains. Not too bad compared to the higher marginal rate you might have faced when you were earning more or living in a higher tax state. Take a spin through my 529 College Savings Plan calculator to see how this plays out for difference scenarios.

Worst case scenario: If you’re a high income earner living in California for 20 years, and you decide to take a non-qualified distribution for the entire amount you saved, it will still work out close to break-even. If you take the distributions for qualified educational expenses, you come out 39% ahead. So in the worst scenario you have a chance at a 39% gain, or breakeven. Seems pretty good.

Screen Shot 2018-03-13 at 4.25.02 PM.png

If you choose to take my advice, and retire in a no-income-tax (NIT) state, you can come out ahead of the game on an after tax basis. So there’s really no reason you shouldn’t contribute to a 529 fund.

Screen Shot 2018-03-13 at 4.22.18 PM

What if you pass away without disbursing the funds?

As a final thought here, one other strategy (if you don’t use the funds) is to simply allow the 529 Plan to pass on to the beneficiary. There is no stated time limit on the majority of 529 plans, so you can theoretically hold it in the tax-deferred state indefinitely. When you pass away, the funds should already have been deemed a gift and will not incur inheritance taxes for you. The beneficiary can then use the 529 funds for educational purposes, or hold onto the funds, letting them grow tax free until a future date when they might opt to pull those funds out one way or another.

Ultimately, the best way to take advantage of the 529 plan is to invest early with the right amount to match what you expect to spend on college. This will you give you the maximum time for your investments to grow tax free, then you’ll save a boatload on qualified distributions. If you want to get fancy, you can start thinking about the tax advantages of estate / inheritance planning associated with 529’s. They can be an interesting vehicle to transfer wealth, but best to consult a tax professional before taking any action with that in mind.

Best of luck!

Ramen-san


Other random questions

  • Can anyone contribute to the 529 plan you open?
    • Yes, relatives and strangers can contribute to the fund you create. Most plans offer easy ways to do this.
  • What count as qualified higher education expenses?
    • Includes tuition; room and board; mandatory fees; and, books, computers, and software (if required). Source

  • Can you use it toward room and board?
    • Yes, but not necessarily the full cost. As long as your son is enrolled at least half-time in a degree program, room and board qualify as eligible expenses to be covered by tax-free withdrawals from the 529 plan. But the maximum amount permitted for off-campus living cost is the amount the college cites as the off-campus room-and-board figure for federal financial aid purposes. Ask the college’s financial aid office for the number it reports to the Department of Education.Utilities and other reasonable living costs can be included, says Joe Hurley, of SavingforCollege.com, as long as the total doesn’t exceed the school’s official room-and-board figure. Source

Key documents & references:

Leave a Reply