InSight

529 College Planning: 102

Financial Planning Dentist

Types of 529 plans

This is one of the largest hang-ups for savers. A history of misinformation and contamination between different types of 529s has generated several misnomers. Simply put: 529 plans are usually categorized as “prepaid tuition” or “college savings plans.”

Our favorite of the two is the college savings plan, and we find that several of the misconceptions that savers have come from the “prepaid” tuition plans.   

For clarity, College Savings Plans work much like a Roth 401(k) or Roth IRA. They are investments made with post-tax dollars (that often carry tax benefits) and the accounts grow and earn income in a tax-free way. These accounts allow you to invest your after-tax contributions in mutual funds or similar investments. Most of the 529 college savings plans we work with offer several investment options from which to choose. The performance of the account will be tied to the investment options you chose, and you should consult a CFP® and your InSight-Full® to manage this risk, and coordinate it with your timing of needs.

The other alternative, a Prepaid Tuition Plan,  lets you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges, sponsored by more than 250 private colleges. These programs are limited in scope, while they can support savers concerned with the rising costs of tuition, they are generally less flexible and have fewer payment and conversion options. They may also carry unique liquidity issues should you plan to change. It is an educational institution that can offer a prepaid tuition plan but not a college savings plan.

What can’t I use my 529 plan for?

The funds and the investments in a 529 plan are yours. You should be able to maneuver and control the funds in the account as you see fit and within your fiduciary scope. Also, you can always withdraw them for any purpose but should be mindful of the consequences.

Chief among these is the earnings portion of a non-qualified distribution will be subject to ordinary income taxes and a 10% tax penalty, though there are exceptions and methods for managing this tax loss.

At the college or post-secondary level, we discussed in “529: 101” the obviously covered costs of education and what the 529s have been expanded to include. Though you should be made aware that there are some costs that you may believe are necessary, but the IRS disagrees. For example, student health insurance and transportation costs are not qualified expenses, unless the college has lines out these associated costs in fees or services from the college. So, parking fees at Denver University campuses might be covered, but a space in a parking lot near campus might not be.

Are 529 plan contributions tax-deductible?

Unfortunately, the 529 is funded with post-tax dollars, and there is no federal tax relief yet. However, here in Colorado and in over 30 other states, they offer state income tax deductions for contributions to 529 plans. But it’s likely that like Colorado, you would be restricted to investing in your home state’s 529 plan in order to claim the state income tax benefit. (Consult a tax professional for more information)

The tax advantage regarding federal taxes comes when the funds in a 529 plan grow. The growth in these plans is federally tax-free and will not be taxed when the money is withdrawn for qualified education expenses.

Can I use a 529 plan to pay for rent?

Yes, with some restrictions. Room and board is now a qualified expense for at least “half-time” or greater students. Consult with the institution for what constitutes a half-time student. 

So for on-campus residents, qualified room-and-board expenses should not exceed the amount charged by the college for room and board. So in this case savers pay the room and board directly to the student housing authority to avoid mismanagement. 

For students living off-campus, qualified room and board expenses are limited to the cost of attendance figures that vary from school to school. Contact the financial aid office for their reports on this figure. In these cases, try to find a 529 fund that supports payment directly to landlords.

What happens if my child doesn’t use the 529 plan?

There are always options for these funds. Hopefully, you are in this situation for a positive reason like a full-ride scholarship or attendance at a service academy. There are a few reasons to seek a waiver however, your earnings will still be subject to federal and sometimes state income tax. If this is the case the 10% penalty is waived if:

  • The beneficiary receives a tax-free scholarship
  • The beneficiary attends a U.S. Military Academy
  • The beneficiary dies or becomes disabled

If you want to avoid paying taxes completely you can resort to the following:

  • Change the beneficiary to another qualifying family member (a parent, child, sibling etc.)
  • Hold the funds in the account in case the beneficiary wants to attend grad school later
  • Make yourself the beneficiary and further your own education
  • Use a 529 ABLE account, a savings account specifically for people living with disabilities
  • Since January 1, 2019, qualified distributions from a 529 plan can repay up to $10,000 in student loans per borrower over their lifetime for both the beneficiary and the beneficiary’s siblings

As we said at the top of this article. you can withdraw any of the money in a 529 plan at any time for any reason. However, the earnings portion of a non-qualified withdrawal will be subject to taxes and a penalty. So in the absence of one of the exceptions listed above, we will usually coach our clients to find one of the other alternatives above and make these necessary changes to their InSight-Full® plan. If you are still contemplating a non-qualified distribution, be aware of the rules and possible tactics for reducing taxes owed.

What happens if the monthly commitment becomes too much for me?

Stop. We frequently have discussions with clients about not making a 529 commitment before the rest of their financial house is in order. Some of the plans have minimum initial contribution requirements but beyond that, the commitment and regularity are entirely up to you. While some families prefer to set up automated monthly deposits because they want to “set it and forget it”, others choose to make lump sum contributions around birthdays, holidays, or other occasions. These details are entirely manageable and part of the maintenance work from a financial plan.

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