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Get an ‘A' in college savings with a 529 plan

05/10/2017

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By Melissa Cothran and Emily Ziadeh

College tuition continues to increase at about twice the general inflation rate.  On average, tuition tends to increase about 8 percent per year.  This means that for a baby born today, college costs may be more than three times current rates when the child begins college.

With tuition rates rising at such a rapid pace, college planning is crucial. It’s ideal to start the college investment process when your child is young, but it’s never too late to start taking advantage of college savings plans.

Do you know the benefits and potential drawbacks of 529 college savings plans?

A 529 college savings plan, named after Section 529 of the Internal Revenue Code, is an education savings plan operated by a state or educational institution and designed to help families set aside funds for future college costs. A growing number of parents and grandparents are taking advantage of these plans. In 1999, investments in 529 savings plans totaled $5.75 billion. In 2014, this amount rose to $244 billion.

529 college savings plans offer a wide range of benefits:

  • Earnings in a 529 plan grow federal tax-free and will not be taxed when the money is taken out to pay for qualified higher education expenses. Unlike other investment accounts, earnings from savings account interest, bond interest, and stock and mutual fund value increases aren’t taxed when the owner takes a distribution and uses the money for qualified education expenses. Qualified education expenses include tuition, fees, books, and room and board. The purchase of computer or peripheral equipment, computer software or Internet access and related services is also considered a qualified education expense as long as it is to be used primarily by the beneficiary during any of the years the beneficiary is enrolled at an eligible educational institution.
  • In most states, earnings are free from state taxes if used for qualified higher education expenses. In Tennessee, contributions to and distributions from Tennessee and non-Tennessee 529 plans are specifically exempt from all Tennessee state, county,and municipal taxes.
  • The owner of the 529 plan remains in control of the funds. With few exceptions, the named beneficiary has no legal rights to the funds, so you can assure the money will be used for its intended purpose.
  • A 529 plan is very low maintenance. You can easily enroll through the plan’s website and set up automatic investments that link directly to your bank account. The ongoing investment management of the account is handled by an outside investment company hired as the program manager or by the state treasurer’s office.
  • Generous contribution limits exist, regardless of income level. Unlike Roth IRAs and Coverdell Education Savings Accounts, 529 plans have no income limits, age limits or annual contribution limits. There are lifetime contribution limits, which vary by plan, ranging from $235,000 to $400,000.
  • You choose the investment strategy that’s right for you and your student.
  • You can rollover your funds into another 529 plan once in a 12-month period.
  • You can contribute to a 529 savings plan and a Coverdell Education Savings Account during the same year. You can also claim the Hope Scholarship credit or Lifetime Learning credit in the same year you withdraw funds from a 529 plan to pay for qualified education expenses.
  • Your child may choose any accredited college, university or vocational school.
  • The savings account may be transferred to another family member. This is beneficial if, for example, the plan beneficiary receives a scholarship and doesn’t need the money in the 529 plan.
  • A 529 plan offers simplified tax reporting. Contributions to a 529 plan do not have to be reported on your federal tax return. You won’t receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals.
  • 529 savings plans offer favorable federal gift tax treatment. Contributions are considered completed present-interest gifts for gift tax purposes, which means they qualify for the $14,000 annual gift tax exclusion. You can also elect to treat a 529 plan contribution of $70,000 as if it were made over a five calendar-year period and completely avoid gift tax. Making this election does require the filing of a gift tax return.
  • 529 savings plan contributions are not considered part of an estate for federal tax purposes.  However, if today’s gift is spread over five years and the account owner dies within the five years, a portion of the gift will be included in the estate.

While there are many benefits associated with using a 529 college savings plan to save for college, there are also a few potential drawbacks.

  • You must use the money for college. If you withdraw the money and use it for something other than qualified education expenses, the earnings will be subject to a 10 percent penalty. The earnings will also be subject to federal and state taxes according to your current tax bracket. If your children complete college and there is money remaining in the account, this money will also be subject to federal and state taxes as well as the 10 percent penalty. Therefore, when investing in a 529 college savings plan, it’s a good idea to err on the side of underestimation.
  • The portfolio allocations may only be changed twice per year or upon a change in beneficiary.
  • Your investment options are limited. For example, if you find an opportunity where your money will earn a higher return and decide to move the money from your 529 savings plan to a different investment vehicle, you will be subject to the 10 percent penalty and federal and state taxes.

The rising costs of tuition make it more important than ever to start saving for your child’s college education. The 529 savings plan is a great option for those who wish to take advantage of significant tax savings and numerous other benefits.

Planning for higher education can be a stressful burden and is undoubtedly one of the largest expenses a family will incur. 529 plans are an excellent resource and allow families to plan smart and early for these inevitable and necessary costs. A professional tax advisor can help you navigate the choices you have when it comes to college savings.

Melissa Cothran is a senior manager in the LBMC tax practice. Contact her at 615-309-2216 or mcothran@lbmc.com.  

Emily Ziadeh is a staff accountant for LBMC Tax Services. Contact her at 615-690-1970 or eziadeh@lbmc.com.