About a year ago, we wrote a Mother’s Day-themed overview of the benefits and attributes of 529 plans here: Six Reasons to Save for Education with a 529 Plan. That post is still a great introduction to the structure and potential benefits of these plans for education savings.
For our next installment, we outline some of the common concerns related to starting 529 plans, and how to manage them.
529 plans can provide a source of effectively tax-free income to fund higher education, and not exclusively college. Nevertheless, we find that 529 plans are still-underutilized aspects of family financial plans. Why?
Here are three education-planning concerns we commonly discuss with clients:
1. Control: Naturally, people desire a feeling of control or flexibility with respect to directing their hard-earned money.
2. Goals: Some people have an aversion to dedicating amounts for a single purpose, especially when the goal is far in the future.
3. Priorities: trying to balance retirement funding and 529 contributions may be challenging.
Many parents and grandparents may be familiar with, or may even have utilized Uniform Gifts to Minors Act (UGMA) accounts to fund college and other wealth transfers. A few have been later horrified to recall the requirement that the owner transfer control of the account to the child at the age of majority, that’s ages 18-21, depending on where one lives. (Yes, you do have to tell him that the money is his.)
In contrast, 529s offer almost all control to the account owner, while still in an arrangement regarded as a gift. Each 529 requires one named beneficiary and one named owner. While multiple donors may contribute to any one account, the owner retains all ownership rights. The owner may choose to change the beneficiary of the account, make distributions as and when needed, and pass ownership at any time to largely anyone. The new owner could be the beneficiary, a family member, a trusted friend or even a trust.
A lack of control is seldom a true obstacle in opting to use a 529. The further one gets from the original plan regarding owners and beneficiaries, the more likely it is that changes come with reduced benefits, but with careful planning, one may avoid those consequences altogether.
Generally, an unqualified distribution from a 529 plan is subject to taxation at the ordinary income tax rate of the recipient plus a 10% penalty. The tax and the penalty are not assessed on the entire distribution, only on the portion of the distribution attributable to earnings in the account.
Not all disbursements must be for college to qualify. Post-secondary education includes any college, university, vocational school, or other post-secondary institution eligible to participate in a student aid program run by the U.S. Department of Education. Further, among other exceptions, if a beneficiary cannot attend because of disability, penalties may be waived even if ordinary taxation may apply.
Fundamentally, the net impact from an over-funded or imperfectly planned 529 need not be fatally damaging if the investment is held for a long time, allowing the full value of tax deferral to compound. Over a 10 to 20-year time frame, conversion of long-term gains to a fully-deferred ordinary income tends to cross over to benefit deferral. As we have described before, time is an asset – use it wisely.
The short answer to this common concern is, fund your retirement. Still, saving for retirement and future education goals may not be mutually exclusive. Many donors, especially grandparents, do not face that either/or choice at all. For retirement savers with limited funds and access to employer plans and matches, it is generally wise to make contributions at least to the extent of matching limits. When retirement contributions have been maxed out, 529 plans are often the next best priority for planned investment.
529 plans, like any strategy with a material tax component, should be carefully considered by each individual in context for exceptions and potential unique circumstances. We often recommend including a trusted tax advisors or attorneys in more detailed financial planning engagements. Not all plans offer all of the potential choices outlined in this post. Your goals must be matched to specific plan provisions and limitations.
Taking the time to create a detailed financial plan with a financial counselor, and reviewing it regularly, can help keep priorities in order. Working through your long-term goals is great exercise for almost any family.
Revolution Partners can assist you and your other trusted professional advisors in evaluating 529 plans for education as well as other aspects of a comprehensive financial plan.
Want to learn more? Check out these other investment management articles on the Realize blog: