Here are eight important facts every parent should know about 529 plans.
1. Earnings Grow Tax Free
When you invest in a 529, the earnings from your investments accumulate tax free. It is also untaxed when the money is taken out and used for qualified expenses.
2. It Can Be Used for More Than College
Funds used can be used for various types of education, including trade, vocational, graduate and technical school. Up to $10,000 per year can be used towards education costs from grades K-12 in private, public, and religious schools.
3. How to Use the Funds
Withdrawals are made by check or electronically to the owner, beneficiary or institution. You will be issued Form 1099-Q, but if funds were used for qualified expenses there is nothing to report on your tax return. The Form 1099-Q, however, does not report whether the distribution is Qualified or Non-Qualified. The account holder is responsible for retaining records to support the type of distribution that was taken.
4. What are Qualified Expenses?
Tuition, room & board, fees, books, and apartment rental while in school are considered qualified expenses. However, qualified apartment rent costs can’t exceed on/off campus housing costs published by the school. Expenses for study abroad are also qualified if the student is enrolled as at least a half-time. Note: Airfare for study abroad does not qualify.
5. Options Exist for Unused Funds
If the 529 beneficiary decides not to pursue secondary education, or has leftover funds after graduation, there are alternatives. For example, the owner may transfer the account to a new beneficiary tax free if the new beneficiary is a family member of the old beneficiary.
6. There are Conditions that Allow You to Avoid the 10% Penalty (but earnings subject to income tax)
If there are no suitable beneficiaries to use the 529 balance, you can withdrawal the funds outright, subject to ordinary income tax plus a 10% penalty. Circumstances that avoid the 10% penalty but are still subject to income taxes are:–
- Beneficiary becomes disabled/ dies. Can withdrawal the full 529 value.
- Beneficiary attends a U.S. Military Academy. Can withdrawal the full 529 value.
- Beneficiary gets a scholarship Can withdrawal up to the amount of the award.
In a scholarship circumstance, first use funds for qualified expenses that scholarships may not cover, like room & board, housing costs for off campus living, textbooks, laptops/computer, etc. Then withdraw up to the amount of the scholarship without penalty.
7. There’s Flexibility in Ownership
In addition to beneficiary changes, 529’s also allows changes to ownership. For example, a grandparent or relative can transfer ownership of the account to the parent for the benefit of the same child. Most 529’s also allow a named contingent beneficiary in the event of untimely death or health event.
8. Advantages over Custodial Accounts
Custodial accounts such as Uniform Transfers to Minors (UTMAs) or Uniform Gifts to Minors (UGMAs) give less control and flexibility to the account owner. Once a custodial account is created, neither the owner nor beneficiary can be changed.
- If the owner dies before the beneficiary reaches age of majority, the full value is included in their taxable estate. A 529 is not included in the decedent’s estate and can be transferred to the contingent owner.
- Moreover, once the beneficiary reaches the age of majority, typically at 18 or 21 depending upon state law , the owner no longer has control of the account. The beneficiary can spend the money freely. With 529’s, the account owner is in control regardless of beneficiary age. The fund use is also limited to education related expenses, unless electing to withdrawal with penalty and taxes.
- While 529 account earnings grow tax deferred, custodial accounts do just the opposite. Any earnings from an UTMA/UGMA over $2,200 are subject to “kiddie tax”. Kiddie tax uses the tax rates of Trusts and Estates, which are significantly higher than ordinary income tax rates.
- Lastly, when applying for Financial Aid, an UTMA is considered the child’s assets. Twenty percent of assets owned by the child are expected to be used to pay for school. In contrast, a 529 is considered the parent’s assets. Colleges expect just 5.64% of “unprotected” parent assets to be used for school. Examples of protected assets include net worth of the family home, retirement plan accounts, and life insurance policies, which are non-reportable to FASFA.
Knowledge is power.
When deciding which college savings vehicle is best for you, remember to consider the flexibility, purpose and tax implications of each. 529’s can be very helpful in paying for education expenses while providing the opportunity to benefit more than one child if needed. Having an investment vehicle with these benefits is just one way to alleviate education-related stress.
If you have questions about 529s or other college savings plans, or would like to learn more, please reach out to our friendly, knowledgeable financial advisors.
About FAI Wealth Management, Inc.: Located in Columbia, Maryland, FAI focuses on helping clients create the financial future they desire by protecting their wealth, making the most of their assets, and planning for life's uncertainties. The firm combines fee-only, fiduciary-driven guidance with highly personalized, consultative financial planning and investment services that enable individuals, families, and businesses to navigate complex life transitions. Founded in 1987, FAI currently manages more than $350 million in client assets nationwide. For more information about FAI Wealth Management, please visit the website at https://www.faiwealth.com or call 410.715.9200.