529 Plans A Simple Overview

What high income parent site would be complete without a guide to 529 plans? Well, here it is. I’ve decided to write it in a question and answer format. I tried to think back to all the questions I had when I was first researching these things.  There are a ton of great resources to figure out what 529 plan is best for you, if you want to go that route for higher education savings. Lets get started.

 

Questions to get you started about 529 plans

 

What is a 529 plan?

A plan operated by a state or educational institution, with tax advantages and potentially other incentives to make it easier to save for college and other post-secondary training for a designated beneficiary, such as a child or grandchild.

Basically, a state has a fund that allows you to invest in different investment vehicles. They are stocks, bonds, REIT’s or a combination of those. Money is deposited by the owner of the plan and managed by the state fund manager.

How does it apply to you as a high income earner?

This is an especially nice way for high income earners to save money on taxes.  You have to look at your personal scenario though.

Let’s say you have an AGI of 270,000 a year want to put aside $10,000 a year for your two children to go to college. If you put it in a taxable account. You would pay 20% capital gains and an extra 3.8% medicare tax on those gains when you withdraw the money.  If you put the money in a 529 and only used the gains to pay for qualified educational expenses, then you pay no tax.  In both accounts you pay taxes on the contributions. If you are in the top tax bracket, that is a significant savings.  As you go lower in the tax brackets and capital gains tax diminishes, it is less helpful.

How do I use a 529 plan?

Pay for Qualified Higher Education Expenses (QHEE).

What are qualified higher educational expenses?

This includes:

  • Tuition and fees
  • Room and board on campus
  • Books and supplies
  • Computer and other technological equipment used for education
  • Internet access
  • If your child has a disability, special needs equipment can also qualify
  • Living off campus can qualify up to the amount the school designates as its “room and board allowance”

Where do I use a 529 plan?

Your student must enroll at least half time at a college, university, vocational school, or other post-secondary educational institution eligible to take part in a student aid program administered by the U.S. Department of Education. Basically, if you can borrow student loans to go there, it’s eligible for 529 funds.

What should I look out for when choosing a 529 plan?

Just like any other investment, low costs are number one. Then ease of access and variety of investments are the next most important items.

Which states have the best 529 plans?

More than likely the best plans for you is Utah if your state doesn’t have a state income tax, or your state plan if the state income tax deduction covers the fees that your state charges.

Savingforcollege.com has a great list of all the state 529 plans by cost. I’ve arranged them by cost from lowest to highest for you. This is without accounting for state income tax deductions.

Should I use a brokerage or a state for my 529 plan?

There are several broker options for 529 plans. Brokerages such at TD Ameritrade, Vanguard, Edward Jones and Merrill Lynch all have 529 plans through their platforms. These 529 plans still have to run through a state. The brokerages just add extra expenses to the cost of investing in the plans.

For example, TD Ameritrade uses the Nebraska plan as its 529 plan. The same investment that has a 0.4% expense ratio in the Nebraska state fund could have an added 0.10-0.25% to that through TD Ameritrade. There is no advantage to going with the brokerages except possibly using the same brokerage to hold your 529 funds as the platform of your other accounts. With today’s online accounts,  I can’t see a reason why someone would use as brokerage. It is just as easy to contribute and withdraw from your plan through the state websites.

 

The expense ratio is higher for the TD Ameritrade Nebraska plan. Expense ratio is in the second to last column. 

 

529 plans

The expense ratio is lower, for the same investment on the Nebraska (NEST) site.

 

529 plans

Same here. Lower expense ratio.

What happens if I don’t use the money for education?

If your student doesn’t need the money or doesn’t have eligible expenses because he didn’t go to college, then a few options exist for you to keep the fund from lingering in limbo indefinitely.

  • Transfer the funds to another student.
  • The parent could use the funds for herself to take some more classes
  • If the student received a scholarship, the parent could withdraw the funds up to the amount of the scholarships and only pay income taxes on the profits (No 10% penalty if the amount matches the scholarship amount effectively making like a traditional IRA)
  • The funds could be withdrawn and used for non education expenses
    • The pitfalls of this, are the profits get taxed at your regular income tax rate, plus a 10% penalty.
    • Also, you can’t just take out the principle. You have to take the funds out pro rata. 

For example, You put $10 dollars in, and made $5 in profit. Then you decide to take $6 out and spend it on non educational expenses. You can’t claim that $6 is all principle. You have to pay taxes on the percentage of profit compared to the whole account. (In this case the profit you spent was $2, so you would pay your regular income tax rate plus a 10% penalty on the $2 since a third of the account value was profit).

Do I get a tax deduction at the state or federal level?

The answer to this is it depends. At the federal level, there is no deduction on the contribution, but as stated before you get to take out the profits tax-free if used for QHEE.

On the state level it is another matter. I can’t do it any better than savingforcollege.com when it comes to state taxes. Check out the image below. Some states give you a deduction no matter which state’s 529 plan you invest in. Others don’t give you a deduction at all. Some states don’t have state income taxes so there is nothing to deduct anyway. Click the image to learn more. 

529 plans

                                                        from savingforcollege.com

How many 529 plans can I have?

You can have as many as you want. There isn’t any regulating agency going around policing how much money you deposit into multiple state 529 plans.  The states have a maximum amount that you can accumulate in a 529 plan though. The current maximums are between $511,758 in Pennsylvania and $235,000 in Georgia. You also have to be wary of the maximum gift you can give to each student. Currently the yearly max is $14,000. You can front load these for 5 years, so each person can gift $70,000 upfront without additional tax filings.

If that still isn’t enough for you, you can give more, but have to file form 709 to record any amount over the $14,000. This will go against your lifetime gift tax exemption. As long as you don’t go as of 2016 over 5.45 million dollars worth of gifts in your lifetime, you pay no tax.

Can 529 plans be a good tax shelter?

If you are looking for ways to tax shelter a ton of money, this could be a viable option, but if another state detects that you are contributing with no intention of using the funds for education expenses, I guess they could investigate you and close your account.

Personally, I think the drawbacks of only using the funds for educational expenses and the 10% penalty would prevent someone from doing this. Plus, the expenses in these funds are a little higher than if you put them in a taxable account and bought low-cost index funds yourself.

I guess you could justify putting aside a lot of money though if you plan for your student to attend Harvard for undergrad, Yale for law school, and John Hopkins for medical school before she earns her PhD in computer science at Cal Tech.

Who owns a 529 plan?

The person opening the account owns the plan.  The beneficiary DOES NOT eventually own the plan, so you the parent still have control over the funds forever.  Now there are a lot of interesting tidbits that come into play with this little fact.

Since we are high income earners, need based financial aid is usually not an option for us, or it is much harder to get.  If the 529 is owned by the parent or the student, the amount in the 529 reduces need based financial aid by 5.64% (in other words, if you have 100,000 in a 529, the students potential Expected Family Contribution (EFC) is $5,640, so you would get that much less in financial aid).

Now if grandpa or grandma ( someone else beside the parent or student) owns the 529, this 5.64% doesn’t apply. If you are right on the border of receiving some financial aid, it might be helpful to have Grandpa own the 529 plan. The drawback of this, is if you withdraw funds from the 529 before the junior year of the student, those funds would count toward reducing potential financial aid in two-year.  (By the way, this is a new rule starting for 2017-2018 school year. The income of the parents and student is judged against the income from two years earlier for financial aid purposes. It used to be one year. The look at 2015 income for 2017-2018 school year. )

Is there a better way to use 529 plan funds?

In a perfect world, if you could back-load your educational expenses to the last two years and withdraw all the 529 money from Grandpa’s account then. That would give you the opportunity for the greatest financial aid throughout the four years of college.

What happens if I take the money out for non educational expenses, but I received a state tax deduction earlier in life?

Some states might recapture the deduction you took before if you don’t use the money for educational purposes. I can’t do it any better that this site to show which states will recapture taxes and what the penalties ensue.

Where are the best websites to look at 529 plans?

There are tons of resource that can probably pin point specific question you have about your situation.  I have tried to paint a broad view, especially for the high income earner.  Here are some more resources.

http://www.savingforcollege.com/529_fee_study/lowest.php

https://www.forbes.com/sites/baldwin/2016/03/03/guide-to-the-best-529-plans/#45a587fb323c

http://clark.com/education/clarks-529-plan-guide/

http://www.magnifymoney.com/blog/college-students-and-recent-grads/best-529-savings-plans

 

Magna Cum Laude

I would recommend maxing out any tax deferred retirement space you have before funding 529 plans. As high income earners that is our best tax and retirement benefit in most cases.  If you are young parents, funding accounts that get taxed upfront, but have tax-free withdrawals could still make sense (i.e. Roth IRA and 529 plans) due to the time you still have for the taxed contributions to make up the difference with greater profits in the long run.  You can work out the best financial strategy for your specific situation if you know the variables and have the right calculators. 

If you have specific questions, please leave them in the comments below or email me and I will do my best to answer them. Do you have any other concerns? Do you used 529 plans?

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Tom
Tom is a doctor and father of five with a passion for parenting and finance. When he isn't skateboarding, riding BMX, or jumping on the trampoline with his kids, he is reading and writing about personal finance. He helps high income parents educate and mentor their kids to become financially, emotionally, and intellectually self sufficient.

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