Introduction to 529 Plans
State-administered College Savings Plans (often called 529 plans) are attractive vehicles for accumulating savings to pay for post-secondary educational expenses. Any individual donor, regardless of income level, can fund an account for any individual beneficiary – while still retaining control over the account. By funding a plan, the donor’s contribution is (in most cases) removed from his/her own estate. The plan’s beneficiary can be changed to any of a wide array of relatives (of the beneficiary) as often as needed.
Once a 529 plan has been funded, investment earnings grow tax-free in the account. Withdrawals made by the beneficiary are federal (and usually state) tax exempt – provided they are used for qualified educational expenses including: tuition, room and board, books, required equipment, and fees. If withdrawals are not used for qualified expenses, the earnings are taxable and trigger a 10% penalty payable by the recipient. At any time, a donor can revoke the plan and take back the plan balance. In this case, any reclaimed earnings will be subject to both income tax and the penalty tax.
In 2017, an individual donor is allowed to make an annual contribution of up to $14,000 toward a beneficiary’s 529 account without gift tax consequences. Using a special election, an individual donor can make a one-time contribution of up to $70,000 (married couples gifting jointly can contribute up to $140,000) to an individual beneficiary’s account. However, if the special election is used, subsequent annual contributions for the next four years to the same beneficiary would have gift tax consequences.
Each state’s plan is unique and offers a limited number of investment choices from one or more financial vendors. The most important variables among 529 plans include state taxation, expenses, and investment flexibility. Currently, 34 states offer either income tax deductions or tax credits on contributions.
Expenses, including set up and/or annual administration fees paid to the state, asset management and/or administration fees paid to the vendor, and commissions paid to a financial broker, can total up to nearly 2.5% per year. Choosing plans with lower fees is an easy way for a donor to help increase the potential for satisfactory long-term account results.
Investment flexibility, which means the number and type of investment choices available to the donor and the ease of making changes to those choices, is often cited as a major drawback of 529 plans. Investment options are limited to those available in each state’s plan, and under most circumstances, changes to those choices are allowed only twice per calendar year. Investment programs will fall into one of three general categories: age-based, static, or self-directed (see Appendices A – C below).
While other college savings vehicles exist and certainly should be considered, recent changes to tax law now often make 529 plans the best option among these choices. Alternative college savings methods are addressed in the following link for our full report.
To select a plan, a donor, after considering other savings methods and any special tax breaks from his/her own state plan, should look for a 529 plan with low expenses and investment flexibility. The linked report includes information on several state plans of interest: Nevada, Ohio, Utah, and Virginia. Because many of WESCAP’s clients reside in California, information about California’s plan is also provided.
Please contact your WESCAP advisor if you have any questions or concerns