Last week, while writing about Arizona’s new ABLE Act accounts, we realized we have not focused on Section 529 plans before. Let’s take care of that now.
What is a 529 plan?
Pardon us for starting off all wonky. “529” refers to Section 529 of the Internal Revenue Code. That tax law makes tax-advantaged education plans possible.
Each state sets up its own college education fund program, and nearly all the states participate. Most of the states operate an investment plan which can be used for college expenses when the time comes.
In the meantime money sitting in the 529 plan account grows tax-free. In fact, there is no income tax on distributions from the plan — provided that they are used for qualified education expenses.
What is a qualified education expense?
Section 529 says that money can be used for “tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution.” Also permitted: payments for room and board (in some cases and with some limitations), some special needs expenditures, and computer expenses. Thanks to changes adopted last year, the 529 plan can even pay for tuition at an elementary or secondary school.
Not everything a student needs will qualify, though. It’s possible that some tax might be due on distributions from the 529 plan when they don’t meet the “qualified education expense” limitation. Even then, though, the tax may be slight. Only the income earned inside the account is taxed, not the whole distribution. There is an additional 10% penalty, but in some cases that might not be much of a payment.
Who should set up a 529 plan?
Anyone who wants to save for college should consider a 529 plan. Do you have a new child? Consider a 529 plan account. Want to set aside money for a grandchild’s education? Set up a 529 plan account.
In our practice, we mostly see grandparents setting up 529 plan accounts. That makes sense. After your children grow up, start their lives and have a family, you are more likely to have available resources. The 529 plan is a great alternative to help out your children without interfering too strongly in their lives.
When you set up a 529 plan for your new grandchild, you can either put up to five years worth of maximum contributions into the account, or set up a small monthly deposit, or anything in between. If you choose to put $75,000 into a new account right now, there will be no gift tax consequence. If $100 per month is more manageable, that will be great, too.
Setting up an account for a grandchild has another side benefit. That gets us to the FAFSA.
How are 529 plans treated on the FAFSA?
Pretty much every applicant for a scholarship, loan or work/study arrangement has to fill out the “Free Application for Federal Student Aid” (FAFSA) form. The FAFSA exposes lots of long-time mistakes made — too often — by family members.
One choice to plan for future needs (education and otherwise) for your new grandchild would be to set up a Uniform Transfer to Minors Act (UTMA) account. UTMA accounts are wonderfully simple to set up and operate, but they get included in the FAFSA computation when it comes time to look for financial aid. Anything directly available to the student may get counted.
If you have set up a 529 plan, however, the result may be different. If you continue to own your education account — even though a grandchild is named as beneficiary — it will not affect the FAFSA calculations.
Putting the account in your child’s name (for the benefit of the grandchild) will make the 529 plan count on the FAFSA again. So most grandparents set up the account, make one-time or periodic contributions, and keep the account in their own name. It makes sense to name another grandparent (your spouse?) as successor custodian of the 529 plan account, too.
I’m sold. Which 529 plan account should I use?
We were afraid you’d ask that. Sadly, it’s hard to figure out which plan will work best for your situation.
Fortunately, there is a great online resource to help you compare plans. The Saving for College website is wonderful, and helps cut through the confusing choices. It even has checklists and questionnaires to help get you to the best solution.
Pay attention to the state-specific benefits. Depending on where you live, there may be a state income tax benefit to setting up a plan — but usually only if the account will be with your own state. There might even be some benefit to using the plan for the state where you know your grandchild will go to college.
Beyond that, you’re comparing investment options, ease of use and costs. You can quickly narrow the list to 3-5 state choices.
How should the account be invested?
You almost got us giving financial advice there. But we know better. You should talk to a financial planner to get suggestions.
Remember, though: you have decided to open up this account right after your grandchild’s birth, and so there will be 15-20 years before the education expenses will need to be paid. That should give a pretty long time horizon for investments to perform well. Plan accordingly.
The bottom line
We hope all that helps you better understand 529 plans. They are a pretty cool way to help save for a grandchild’s — or a child’s, or a good friend’s child’s — education costs.
Should you set one up? Let us put it this way: whenever a client tells us that they want their estate plan to include money for their grandchild’s education, we always give the same advice. We suggest a 529 plan as the most tax-efficient, disciplined and productive way to help educate a grandchild.