College Savings – 529 Plan

A prepaid tuition plan allows you to purchase a future education while essentially locking-in the current price for in-state public institutions. With larger tuition hikes approved year after year, this plan becomes an appealing way to guarantee the future price of tuition. States such as Florida will also typically guarantee investments in a prepaid tuition plan. However, they normally require either the beneficiary or the owner of the plan to be a resident in order to benefit from the plan. Additionally, the cost per credit is often determined by the number of years that the beneficiary has before he or she reaches a certain age, which is normally calculated as the age that students typically begin attending college.

A 529 Educations Savings Plan operates in a similar way to a Roth 401(k) or a Roth IRA in that it invests your contributions on an after-tax basis with the investments inside the plan subject to market risk with no guarantee that it will increase in value. Once the beneficiary is ready to use the funds to pay for their education, you may make tax-free withdrawals up to the amount of qualified education expenses. Unlike a prepaid tuition plan, an education savings plan does not discourage the use of funds for out-of-state or private tuition nor does it require that the owner or beneficiary be a resident of the state.

In short, it often comes down to taxes. Similar to a Roth IRA, money invested into a 529 plan is on an after-tax basis. Meanwhile, earnings on investments inside the plan accrue on a tax deferred basis. What this means is that while you do have to pay ordinary income tax on the money that you place into the plan, the investments’ earnings are not treated as taxable income and withdrawals will not be faced with a capital gains penalty. For example, if you fund a 529 plan with $10,000 and the account grows by 4 percent in a year to $10,400, that $400 in growth will not be taxed when later withdrawn to cover qualified education costs. As a result, a 529 plan over time easily becomes a lucrative tax break worth thousands of dollars in savings.

Unlike a Roth IRA, the tax break savings that are a part of the 529 plan is not diminished on the basis of the owner’s income. There are also no income limits to 529 plans so if your income is high and you are disqualified from contributing to a Coverdell ESA, you will be able to open a 529 plan.

Although there are no annual contribution limits to the 529 plans, states may restrict the dollar amount of contributions that will qualify for an income tax break. One concern that some have has to do with the federal gift tax exclusion and how it may apply to contributions made to a 529 plan. As of 2018, you are allowed to gift up to $15,000 for each beneficiary without being subject to a federal gift tax penalty. However, the IRS does offer an alternative to the lifetime gift tax exemption, which has earned the moniker of “superfunding”. This allows you to fund a 529 plan with an amount that can add up to 5 years of education expenses all at once for a total contribution limit of $75,000 for each parent. Importantly, when choosing this option of funding, the large contribution will not go towards your lifetime gift tax exclusion limit. This could also have positive consequences of allowing your money to compound over time, resulting in a greater amount of earnings on the investments inside the plan. For example, instead of contributing a small amount to a 529 plan each year, you could choose to fund your young child’s 529 plan with a large lump sum amount and watch your investment grow over a period of let’s say 18 years. Therefore, you could be able to benefit from a greater accumulation of investment earnings that can later be withdrawn on a tax-deferred basis.

Unlike the Coverdell ESA, you are not required to withdraw the plan funds once the beneficiary turns 30, giving the beneficiary the option to use the funds for higher education expenses at a much later date.

It is important to note that the 529 plan can go towards technical or vocational school expenses as well. Also, most 529 plans allow you to change the beneficiary once per year, which gives you the option of transferring the plan to another one of your children whose plans may include attending college. If neither of these options are attractive, as a last resort you may cash out the 529 plan and choose whether the funds will be payable to yourself or to the beneficiary. The recipient of the withdrawal will incur a few tax and penalty charges. Since the money in a 529 plan will be used for something other than qualified education expenses, the recipient will have to pay both federal income taxes and a 10% penalty on withdrawals. As a result, it is always a good idea to exercise caution when choosing to cash out your 529 plan as decisions can change and your child may in fact decide to attend college later on in their life.

If the beneficiary of a 529 plan receives a scholarship for college, the penalty for cashing out the 529 plan is waived.

Under the new Tax Cuts and Jobs Acts, families have the option of annual tax-free withdrawals up to $10,000 in order to cover private elementary and high school costs. However, doing this does diminish the benefit of enjoying the compounding growth of contributions ahead of college.

Absolutely! The common misconception among many people is that you will only be able to use your prepaid tuition plan for in-state public colleges. While you may not receive the full value of your plan, many states that offer prepaid tuition plans will allow you to transfer the value of the plan to private or out-of-state colleges. For example, Florida Prepaid Plans will pay out funds in an amount that is equal to the weighted average tuition and fees of the state’s public institutions.

Each of our advisors at Florida Financial are knowledgeable on the different types of 529 plans available and can help guide you to make sure a 529 plan is the right choice for you. Contact us today for a free consultation