Saving For College – 529 Plan

October 20, 2016 | By Jon Powell, CFP®| Savings

We wrap up our three-part college savings series by taking a look at how to utilize a 529 plan to save for college. We’ve already addressed whether college savings can fit into your financial plan and how much college is going to cost.

Once it’s clear that you can save for college (because your own retirement is taken care of) and have figured out how much you need to put away, we can begin funding a 529 plan.

529 plan rules are governed by individual states which has made them notoriously confusing to consumers seeking advice on the internet. Different states have different contribution limits and / benefits.

This is further complicated by the fact that you can use any state’s 529 plan, not just the state you live in. Some 529 plans offer better investment choices than others. It’s important to weigh your options when choosing a 529 plan in which to invest.

Federal Tax Benefits

On the federal level, you will not get a deduction for contributions made to a 529 plan. However, all of the earnings will be tax-free if used for qualified higher education expenses. In practice, this ends up functioning similarly to a Roth IRA, with which you may be more familiar.

Be careful about how you make distributions from a 529 plan, as non-qualified distributions will lose their favorable tax treatment and will be subject to a 10% penalty. You have three main options when making distributions to satisfy the rules:

  1. Directly pay the school from the 529 plan for bills received.
  2. Reimburse yourself for expenses that you have already paid (save your receipts)
  3. Reimburse your child for expenses they have already paid (make them give you the receipts!)

State Tax Benefits

Individual states differ on how they treat your contributions. Some states allow you to contribute to any state’s plan and still receive a deduction in your home state. Other states require you invest in your home state’s plan in order to receive state tax benefits. There are a few states that do not offer any deduction for 529 plan contributions. You can research a specific state’s tax consequences and plan options, but I will lay out the states that are local to many of our clients:

Maryland – Individual residents may deduct up to $2,500 per beneficiary and married couples may deduct up to $5,000 per beneficiary.

Contributions in excess of the annual deduction limit may be carried forward for ten years. Maryland residents do not receive tax deductions for contributions to another state’s 529 plan.

Virginia – Each resident may receive a deduction of up to $4,000 per account. Therefore, a married couple could have each spouse open a separate account for each child and receive multiple $4,000 deductions.

Contributions in excess of the annual deduction limit can be carried forward to future years, indefinitely. Virginia residents do not receive tax deductions for contributions to another state’s 529 plan.

District of Columbia – Individuals may receive a deduction of up to $4,000 and married couples may receive a deduction up to $8,000 for contributions into a District of Columbia 529 plan (not per account or beneficiary).

Contributions in excess of the annual deduction limit may be carried forward for five years. D.C. residents do not receive tax deductions for contributions to another state’s 529 plan.

Contributing to a 529 Plan

Most states do not have limits on contributions to 529 plans the way you may be familiar with limits on your 401(k) or an IRA. For example, Maryland has no annual limit on contributions to their 529 plan.

Instead, there is a lifetime limit of $350,000 on the account value per beneficiary. In most cases, the contribution limits on 529 plan accounts will not come into play for savers.

However, you do need to be aware of federal gift tax limits when making contributions. For 2016, the annual gift tax limit is $14,000/year ($28,000 for married couples) before you will be required to file a gift tax return.

Alternatively, laws allow a lump-sum contribution of $70,000 at one time to be carried forward over five years to avoid gift tax triggers, as well.

Investing Within a 529 Plan

Fortunately for consumers, most 529 plans have reasonably simple investment options available.

Most that I’ve come across allow individuals to construct globally diversified, low-fee portfolios. In many cases, target date funds are available which can be matched to the year your child will begin college.

There are drawbacks to these types of investments, but they could be worse. It is important to ensure that you are matching the underlying investment allocation to your goals and not blindly investing based on the date in the fund’s name.

Some states have partnered with institutions that have employed high-cost investment options for 529 plan participants (South Dakota comes to mind).

In cases like these, you will need to weigh the tax benefits against the costs of investing in order to determine if utilizing your home state’s plan is worth the fees.

If you’re lost, it’s usually wise to consult your financial advisor before investing in your specific state’s plan.

This concludes our tutorial on saving for college. If you would like to know more, please contact one of our advisors for a more specific look at your personal needs.

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