While a lot of people would love to pay to have their child or even a grandchild attend college, that’s a huge expense. Depending on the educational institute, textbooks, and any additional expenses such as labs, that can easily go into six figures.
The 529 Plans
What may seem like an impossible dream could become a reality, thanks to 529 plans. These plans benefit families regardless of income bracket. As a tax advantage, 529 plans not only help with sending kids to school, but they also have some estate planning perks.
The 529 plans are part of the Internal Revenue Code. They create an opportunity for investment earnings to grow and provide protection from federal income taxes and, sometimes, state-level income taxes. Another advantage is that withdrawals used to pay for college expenses are non-taxable.
As for estate planning, 529 plans help with long-term gifting strategies while giving you substantial control over any assets taken out of a taxable estate.
Types of Plans
There are two types of 529 plans:
1. College Savings – You can select from a variety of investments. As a result, your return potential increases. However, so does any risk.
2. Prepaid Tuition – This makes it possible to lock into future tuition but at current rates.
Qualified Beneficiaries
With 529 plans, you can select your beneficiaries. The list includes your mother, father, brother, sister, son, daughter, grandchildren, niece, and nephew.
Additional Information
Generally, both these 529 plan types have state government sponsorship even though one or more investment companies administer them. However, as permitted by law, some educational institutes can sponsor the prepaid tuition plans. As for the college savings plans, mutual fund companies typically manage these.
As the beneficiary becomes older, a lot of 529 plans offer asset allocation portfolios based on age. These become increasingly more conservative. Some of these plans will let you create a customized portfolio by selecting from a list of individual investment options.
Initially, 529 plans had a tax deferral benefit, meaning people didn’t pay taxes on earnings until withdrawal at the beneficiary rate. As mentioned, withdrawals, which are federally qualified and, sometimes, state-qualified, are tax-free. There’s no income or age limitation to contribute to either 529 plan type. For total plan contribution limits, these often go beyond $200,000.
529 Plan Withdrawals
Withdrawals are diverse. For instance, you can use them to pay for either undergraduate or graduate college expenses. You can also use withdrawals to pay for the enrollment or attendance to an elementary or secondary private, public, or religious school. These all qualify as “higher education expenses” as outlined by the Internal Revenue Code.
Now, you would have to pay applicable state and federal income taxes for any withdrawals used for expenses that don’t relate to qualified higher education. On top of that, if a specific exception doesn’t apply, you’d get hit with an additional 10 percent federal tax.
The withdrawals for elementary or secondary private, public or religious schools have a $10,000 cap per beneficiary for each calendar year. You aren’t limited to withdrawal options offered in your state. Rather, you can participate in a national plan sponsored by an entirely different state. Remember, it’s possible to see state income tax applied to 529 plans available in your state.
Do 529 Plans Make Sense For You?
Sometimes it does not make sense to contribute to a 529 plan if it means you have to take away contributions from a 401(k) or IRA plan. These types of retirement plans have contributions that allow you to deduct from federal income taxes. A 529 plan does not have this benefit.
These types of calculations can get complicate so it is best to consult a financial advisor or use a sophisticated retirement planning software package, such as The WealthTrace Planner, to help you figure this out. If you only want a quick overview of the benefits of a 529 plan, you can use a free calculator to help you.
Estate Planning
When the government created 529 plans, its focus was college planning. However, it also provided tools that could help with estate planning. This is because Congress considers contributions as a completed donor gift to the named beneficiary on the account. Now, even if the account holder isn’t the beneficiary, that individual would still have control of the money while it’s in the account.
According to federal law, a single person can donate $15,000 and a couple $30,000 to any number of people each year, which isn’t subject to federal gift taxes. For instance, as a single person, you could give your child or grandchild $15,000 every year.
Here’s how 529 plans benefit. As long as you don’t make any taxable gifts to your beneficiary beyond the $15,000 annual contribution, you don’t have to worry about taxes.
If preferred, you can boost your gift-giving schedule with a lump-sum contribution. Using the same $15,000 per year scenario, you could contribute $75,000 to a 529 plan during the first year of a five-year stretch. For couples, that would increase to a lump-sum contribution of $150,000.
However, if you provide your beneficiary with additional gifts during those five years, you might have to pay a gift tax. If you opt for this accelerated option but pass away before the five-year timeframe ends, a prorated amount of the contribution would become part of your taxable estate.
The 529 plans increase the potential to transfer wealth. Here’s an example of how it might look. A single person with five grandchildren can immediately remove as much as $375,000 from the taxable estate simply by making contributions into five separate 529 plan accounts. Then, in five years, that individual could repeat the process.
Key Takeaways
A few takeaways – you remain in control of your money. Along with deciding how it’s invested, you determine the beneficiary, which you can always change. If your beneficiary doesn’t attend college, there’s no triggered tax consequence.
Keep in mind that rules vary by state and there are other factors associated with these plans to consider.
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