Let’s jump right in and start with the way college savings plans are taxed, and then we will talk about the 529 plan. Next week we will talk about some other types of college savings plans like the Coverdell College Savings Account and using a Roth IRA to fund secondary education.
Taxable vs. Tax-Free
We’ll start by quantifying the potential tax impact on college savings with an example. In this example, we assume an initial investment of $25,000 was made when the child is born, a 6% annual return, and a total federal and state tax rate of 28%.
Over 18 years, that $25,000 in your mutual fund would have grown to $53,525, while that same amount in your 529 plan would have grown to $71,358, a difference of almost $18,000. That’s $1,000.00 a year for each year for eighteen years and a lot of money for doing nothing other than saving in one account versus another.1,2
With that little example, you can bet we are talking about 529 plans, one of the most common tax-advantaged college savings options, next.
A 529 plan is a college savings vehicle that offers federal and state tax advantages, and it can also be used to save for K-12 expenses.
In general, 529 plans are sponsored by states, but they must follow federal law. Specifically, they must abide by Section 529 of the Internal Revenue Code, hence the name "529" plan. Long story short, Section 529 plans were created by Congress in 1996, and since that time, they have revolutionized the way parents save for college, much like 401(k) plans revolutionized the world of retirement savings.
There are two types of 529 plans to choose from - college savings plans and prepaid tuition plans. With either type of plan, when you open an account, you control the account as the account owner, and your child is the beneficiary.
So, what makes them different?
We’ll start with college savings plans, which are individual investment-type accounts similar to a 401(k) plan. Every college savings plan offers several investment portfolios that typically consist of groups of mutual funds and range from conservative to aggressive in their amount of risk. Your contributions are funneled into whatever investment portfolios you choose when you open your account. Keep in mind that your returns aren't guaranteed; they will depend on the performance of the investment portfolios you've chosen. For example, if you’ve chosen a more aggressive plan, you have the chance to make extremely high returns, but the risk of low or no return is always possible. If you have chosen a more conservative plan, a steady return is more likely, but your shot at a hefty return diminishes.
If a college savings plan seems attractive to you, you’re in luck because nearly every state offers one, and some states even offer more than one. The best part? You can join any state's plan no matter where you are. Of course, there are a couple of things to consider, but you have a lot of options to choose from for the most part. When college time comes around, money in the account can be used to pay tuition, fees, room and board, books, and supplies at any accredited college in the United States or abroad, including graduate school.
Okay, now for a 529 prepaid tuition plan. This plan is essentially a contract between you and the plan whereby the plan offers to cover a certain amount of in-state public college tuition in the future based on the amount of your contribution today; in effect, you are prepaying tuition at your state's public colleges. This isn’t as widespread as a regular college savings plan, which is why only a handful of states offer prepaid tuition plans, and you are limited to your own state's plan. That means if your state doesn't have one, you are out of luck. But if there’s anything that a businessman loves, it’s loopholes. This is why there is one option for you to explore if your state doesn’t offer the option for prepaid tuition.
There is currently one active private prepaid tuition plan that is sponsored by a consortium of private colleges. Residents of any state can join that plan, but your child must attend one of the participating colleges in order to get maximum benefits under the plan. This is an excellent opportunity for you to participate in prepaid tuition. Yet this isn’t right for everyone, so we will spend more time delving into a 529 college savings plan instead. This is also because they are more common and likely what most parents will choose when the time comes.
Since we will be focusing on college savings plans, let’s focus on the good stuff by looking at some of the advantages of college savings plans in more detail.
First of all, anyone can open a 529 account, regardless of income level. And I should mention here that you don't need to be a parent to open a 529 account; a grandparent, relative, or friend can open an account and contribute money on behalf of your child. Or these people may contribute to a 529 account that you have opened for your child. Also, your child can have more than one 529 accounts opened on his or her behalf, which means be nice to both grandmas just in case.
Second, 529 plans have high lifetime contribution limits, typically $350,000 or higher. Keep in mind, every state sets its own limit, so it’s best to do some research or at least make your trusted advisor do that research for you, wink wink. With these plans, you can contribute as little or as often as you wish. If you’re especially good at procrastinating, you can set up automatic monthly contributions and put your savings efforts on autopilot, or you can contribute lump sums at random intervals. And speaking of lump sums, 529 plans also have a unique built-in feature that allows large, lump-sum, tax-free gifts, which I'll talk more about in a moment.
Third, as an account owner, you maintain control of the funds in the account, not your child. I can hear the collective sighs of relief all the way from your homes to my office.
Fourth, most plans offer age-based portfolios. Age-based portfolios are significant because they act sort of like automatic breaks to keep your child’s funds safe as they get closer and closer to college. In other words, underlying investments automatically become more conservative over time as your child gets closer to college-age, similar to a target-date retirement fund. This eliminates the hassle of having to do this yourself.
Finally, the best advantage of 529 plans is the tax benefits. Your contributions accumulate tax deferred, which means you don't pay income tax on your earnings each year. Then at college time, any gains in the account are completely tax-free at the federal level - and typically at the state level, too - so long as the funds are only used to pay for qualified college expenses. The result is that 100% of your earnings are staying in your account as part of your college fund instead of Uncle Sam sneaking in and stealing it.
This combination of advantages has generally been favorable enough to become a favorite amongst parents and the children who benefit from it.
Now, of course, we have to look at the disadvantages. But let’s put that off for as long as possible by talking about something we like instead: gifts.
I talked about this a little bit earlier, but I just want to make sure to reiterate before we move on: the unique feature of 529 plans is that they allow for large, lump-sum, tax-free gifts in the form of accelerated gifting. This can be a favorable way for grandparents to contribute lump sums to their grandchildren's education, possibly as part of their overall estate planning.
But how exactly does it work?
Under special rules unique to 529 plans, grandparents (or anyone) can make a lump-sum gift to a 529 plan of up to five times the annual gift tax exclusion amount. In 2022, the annual gift tax exclusion is $16,000, so a lump-sum gift can be made of up to $80,000 for individuals or $160,000 for married couples. If the gift is treated as having been made in equal installments over five years on your tax return and no other gifts are made to that beneficiary during the five years, then no gift tax is owed. Five years later, another lump-sum gift can be made again in this manner, and so on.
This is a great way for loved ones to contribute to the future of your little bundle of joy or to anyone who agrees that you might lose your mind if that bundle of joy stays for more than 18 years. Either way, this little perk is a good incentive for people to help your kid save and help you save for them.
Okay, now it is actually time to talk about the disadvantages of 529 plans. But don’t worry, they aren’t scary.
First off, as I mentioned earlier, the returns in a 529 plan aren't guaranteed; in fact, you could lose money.
Okay, that sounded a little scary, but hold on. Typically, 529 plans are great savings vehicles and one of the best ways to get your savings started. It doesn’t have a guaranteed return, but most things don’t. I just have to mention it, so my head doesn’t end up on a chopping block later.
Second, you give up some investment control when you join a college savings plan because you're limited to the plan's pre-established investment portfolios. If you're unhappy with the performance of the investment options you've chosen, you can change the options on your existing contributions only twice per year. (However, you can generally change the investment options on your future contributions at any time.)
Third, you only get tax-free earnings if you use the funds for college. Suppose you withdraw money for any reason besides the beneficiary's qualified college expenses. In that case, you'll owe income tax on the earnings part of the withdrawal - at your tax rate - plus a 10% federal penalty on the earnings. So, again, please do not use your kids' college savings as a checking account. I know they use your savings as a checking account, but we must take the high road here, guys.
Finally, fees and expenses are associated with 529 plans, including investment fees and possibly an annual management fee. Again, this sounds off-putting, but most investments are shrouded in some type of fee at some point. I mean, when was the last time anything came without a fee? Exactly. So try not to hold it against them.
Next week, we will continue our discussion of college savings vehicles, until then be well and please let me know of any questions.
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Until next time...
1 J.P. Morgan Asset Management. The example assumes an initial $25,000 investment. Example also assumes an annual investment return of 6%, compounded monthly, and a federal tax rate of 28%. Investment losses could affect the relative tax-deferred investing advantage. This hypothetical example is not indicative of any specific investment and does not reflect the impact of fees or expenses. Each investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision, as the example may not reflect these factors. These figures do not reflect any management fees or expenses that would be paid by a 529 plan participant. Such costs would lower performance. This chart is shown for illustrative purposes only. Past performance is no guarantee of future results.
2Earnings on non-qualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes.