Key Considerations for 529 Plan Investments

College can be expensive. Tuition costs have increased steadily over the past 30 years. Housing, transportation, food, books, and other education-related fees can add thousands to an already steep college price tag. To prepare, some families want to start saving for higher education early. One savings option is a 529 plan.

What is a 529 plan?

A 529 plan is an investment account that provides tax-free earnings growth and tax-free distributions when the funds are used for qualified education expenses.

Primarily earmarked for college and university expenses, 529 plan funds can also be used for qualified expenses of trade schools; K-12 public, private, and religious schools; registered apprenticeships; and student loan principal and interest incurred by the beneficiary (up to a limit). Qualified expenses typically include school tuition, fees, room and board, textbooks, computers, equipment, and supplies.

If your family is thinking about investing in a college savings plan, there are several key considerations for 529 plans you should examine before getting started.

50 states, many 529 plans

Every state offers at least one 529 plan, and investors are free to choose a plan in any state. It’s important to keep in mind that other states’ plans may be a better choice than going with your own state’s plan. Tax benefits for contributions in your home state’s 529 plan may not be as advantageous as plans in other states. So shop around.

Oregon has a relatively high income tax rate, so 529 plan contributions can generate pre-tax savings right away. However, Oregon no longer provides a state tax deduction for contributions to its 529 plans. Instead, Oregon taxpayers are eligible to receive a tax credit based on a sliding scale as determined by the amount contributed and their income.

Washington doesn’t collect income tax, so you won’t see as immediate advantages, but benefits can build if your 529 plan investments produce gains.

Other considerations you should consider when looking for a 529 plan include plan offerings and cost as well as the advantage of simplifying your financial life by not spreading accounts over multiple platforms.

Current status of your retirement funding

For the benefit of both you and your children, your retirement funding should be on track before you consider funding a 529 plan — as you would do on an airplane, put on your own air mask first!

Time horizon

Keep in mind that the shorter the time horizon, the less time there is to accumulate material earnings to which the tax benefit is applied. If you have a short timeline, plan restrictions on how the funds are used may negate the advantages of a 529 account for your particular situation.

The sooner a family creates a 529 savings account, the significantly greater likelihood that growth of your college savings will outpace inflation. The early years are typically when accounts have more allocated to equities and consequently higher expected growth in value.

Tuition inflation also tends to outpace base Consumer Price Index (CPI) inflation. This underscores the importance of appropriate asset allocation and why delaying contributions to a 529 plan may be costly.

Expected use of funds

If the beneficiary may not go to college, or if the intention is to use the funds for K-12 education, a 529 may not be the best option for you.

The 2017 Tax Cuts and Jobs Act expanded 529 plan qualified expenses to include K-12 educational expenses, allowing funds to be withdrawn tax and penalty free for tuition (up to $10,000 annually).

However, not all states recognize the tax break at the state level. Oregon, for example, does not consider K-12 tuition as qualified expenses under its state 529 program; withdrawals may be used to pay for K-12 expenses in Oregon, but earnings are taxed at the state level. Federally, withdrawals would be tax- and penalty-free.

Impact on financial aid

In some cases, financial aid benefits may be reduced.

Take, for example, if the 529 account owner is a grandparent. When the grandparent withdraws funds to pay their grandchild’s educational expenses, 50% of the distribution (above an annual income allowance) will be counted as student income on their FAFSA form. In comparison, if the account owner is a parent and funds are withdrawn, 0% of the distribution is treated as student income.

Financial aid benefits may also be reduced if the account owner is the student with a Uniform Transfers to Minor Act (UTMA) or Uniform Gift to Minors Act (UGMA) custodial account. UTMA and UGMA accounts are managed by the parent until the minor is an adult, at which point control passes to the child.

However, some states offer financial aid incentives if you meet certain requirements, such as the beneficiary attending school in that state and investing for a certain amount of time.

Unqualified withdrawals and scholarships

If you withdraw funds for unqualified purposes, you will face some loss: a 10% penalty as well as ordinary federal and state income tax on any earnings (though no tax penalty on the principal).

If the beneficiary receives a scholarship, funds from your 529 account may be distributed without penalty. But note that earnings will be taxed as income.

Beneficiaries

With a 529 plan, there can only be one owner and one beneficiary at a time. But you may find yourself in circumstances where you need to change the beneficiary on a plan: for example, you have leftover funds in your 529 plan after the student completes college.

Beneficiaries may be changed as long they are in the same family, as defined by the IRS, and include but are not limited to parents, siblings, nieces, and nephews of the original beneficiary.

Note that if a 529 plan was set up as a UTMA or UGMA, the account is owned by the child and may not be changed by the guardian to another beneficiary.

Contribution limits and gifting

While the IRS does not set a limit on how much money may be deposited into a 529 account annually, any contributions you make count as gifts for gift-tax purposes. A contribution of up to $15,000 per donor per beneficiary qualifies for the annual gift tax exclusion, the amount of money you can transfer to another person as a gift without incurring a gift tax.

However, a special 5-year gift tax averaging rule permits a contributor to superfund a 529 account. You can deposit up to 5 years’ worth of gifting ($75,000 single/ $150,000 joint) as a lump sum with a 5-year election, reported on Form 709 for each of the five years. The gift won’t count toward the lifetime estate and gift tax exemption when properly reported on your tax return. As such, contributing to 529 plans can be an effective wealth transfer mechanism.

Some states have other contribution restrictions, which may be an aggregate maximum or a level at which no further contributions may be made.

In Oregon, further contributions are not permitted if the account value is $400,000 or higher. Earnings may continue to accumulate beyond the maximum value.

Alternative funding options

Roth IRAs, Coverdells, and direct gifting to the educational institution are all alternatives to a 529 plan. Each option has its own unique structure, limitations, and tradeoffs.

A Roth IRA is traditionally a vehicle designed to save for retirement, and, as previously stated, it is important to prioritize your own retirement over saving for college. In addition, Roth accounts have low annual contribution limits (currently $6,000 if under 50 years old), and unless the account holder is at least 59.5 years of age and has had the account for at least 5 years, the earnings may be taxed.

Coverdells may be used to pay for K-12 education qualified expenses at both private and public schools as well as higher educational institutions. However, contributions are limited to $2,000 a year per child regardless of the number of donors, and income phaseout limits cap out at $220,000 based on modified adjusted income.

A direct transfer made to a qualified educational institution on behalf of others for the payment of tuition and fees is not considered a gift for gift tax purposes and may be done to reduce one’s taxable estate.