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When Does a 529 Make Sense?

You went to Northwestern. Your partner went to Northwestern. Now, baby number one is here and they’re already geared up in a purple-and-white onesie. It’s a safe bet that baby number one will probably apply to Northwestern. As stated previously, there are myriad options when it comes to choosing how you save for your child’s education. However, the 529 plan is typically the most common choice.

What is a 529 Plan?

A 529 plan is a state-sponsored, tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans, legally known as “qualified tuition plans,” can also be sponsored by state agencies or educational institutions and are authorized by Section 529 of the Internal Revenue Code. There are numerous investment options in a 529 plan account and if your child receives a scholarship, you can withdraw the scholarship amount penalty-fee and transfer the funds to another beneficiary. Adversely, if you take out money from your 529 plan account to use for non-education expenses, you’ll incur a heavy penalty, and will also pay ordinary federal income tax and applicable state taxes if you received a deduction for your contributions.

Who Should Use a 529 Plan?

529 plans are primarily geared toward families who are fairly certain the beneficiary will attend college. Most plans offer valuable tax benefits and can be an attractive option for more “hands-off” investors (assuming an aged-based option is available). But there are tradeoffs. Here are some items to look out for and be aware of:

  • High fees
    College savings plans sold through a broker may be loaded with commissions and fees, just like any other investment product. If fees are high, the tax benefits could fade relative to purchasing low-cost ETFs elsewhere.
  • Minimal control over the investment strategy
    According to the IRS rules, you can only adjust your 529 plan investments twice a calendar year (rather than the once-yearly change permitted under previous Internal Revenue Service restrictions). That’s a pretty significant downside in a volatile market. Investors looking for greater flexibility over investment choices might opt for a different plan.
  • Minimizes your child’s financial aid eligibility
    529 plans count as an available asset when the federal government and colleges calculate financial aid.
  • Living in a no-income tax state
    If you live in a state that provides a 529 deduction, choosing a plan in your state likely makes sense. If not, costs matter.

Frontloading Your 529 Plan

High-income earners (or people with a large enough estate) can put up to five years of the annual gift exemption into their children’s 529 accounts without gift tax issues.

When you front-load your 529 plan, your earnings will be compounded on more money over a longer time period. This means the more you put in initially, the longer that money has to grow and the greater the balance when it’s time to pay tuition. For example, you can contribute $70,000 (or $140,000 if you gift-split) into the 529 while your child is young to enjoy more years of investment growth and compounding. There is a true benefit in the ability to open a 529 plan, front load it and, at the same time, eliminate that amount from potential estate taxes. It’s also a very good use for a big bonus or inheritance.

With rising costs of college, it seems impossible to overfund a 529 plan but it does happen. As a reminder, for your funds to be withdrawn tax-free, the money must only be used toward qualified educational expenses.

So, in the event you did overfund the account, the best choice is to use the surplus funds for another family member or even yourself if you decide to go back to school. If there is no alternative recipient and the excess funds are withdrawn, a 10% penalty and taxes will be due only on the earnings (not the original principal).

For example, if your 529 account balance after all educational bills are paid is $6,000, and $2,000 of that amount makes up the earnings, the penalty would be 10% of $2,000 or $200. Income tax at your current tax bracket would also be owed on the $2,000.

* Any amount over the amounts in the above chart can be placed in the UTMA/Minor accounts.

What to Do if You Overfund Your 529?

Remember: many children will get scholarships, decide to go to community college for at least one year or decide not to go to college altogether. Roughly 70% of graduating high school students will attend some type of college, meaning 30% will not. The more children you have the greater chance at least one will not require a full four-year university. If your child gets a scholarship, you can pull the equal amount out without penalty. If one of your children does not attend college, money can be transferred to another qualified beneficiary to be used for
education. Qualified beneficiaries include immediate family members, relatives of your
immediate family (e.g. nieces, uncles, etc.), in-laws, and first cousins.

Keep in mind, a 10% penalty and ordinary income tax are charged on investment gains for non-qualified distributions. There is no penalty or taxes on principal – you would only pay a penalty on gains that you have deferred for a long period of time.

If you are concerned about overfunding or not using a 529 plan, we generally recommend targeting a 529 plan for about 70% of the total expected college costs. Then you can transition to a taxable savings account until you reach the target savings amount. Still concerned about overfunding? You may want to try funding only your child’s first two years of college. Then, you can use a Roth IRA or taxable account – or your child can take out a loan – to fund the final years.

Our Takeaway

529 plans are helpful and appropriate in most situations. But in some cases, there can be other ways to invest that don’t have as much of a reduction to financial aid, limit investment flexibility. Consider your situation and goals to best determine which approach makes sense for you. Overall if you choose the right 529 it can bring significant tax benefits and allows for a lot of flexibility if you need to adjust beneficiaries.

Download the free Personal Capital Education Planning Guide

Personal Capital Education Planning Guide Series

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

Amin Dabit is the Vice President of Advisory Services at Personal Capital. Amin brings over a dozen years of experience in private wealth management and financial planning. Amin leads Personal Capital's advisory team to identify and establish strategies for reaching clients' financial goals by providing comprehensive, customized financial advice designed to improve their financial lives.
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