ESTATE PLANNING WITH 529 PLANS

As the month of August came to an end, I prepared to send my oldest child to college.  This entailed not only shopping for twin XL sheets and sharing my wisdom with her but paying that first tuition bill.  I thought to myself as I stroked that check, “how do people do this?” How are so many families fortunate enough to not only have a college-worthy child in their brood, but to be able to send that child to college without breaking the bank? 

            This may not surprise you, but college costs have skyrocketed in the last thirty years.  According to the College Board, the average in-state student attending a public 4-year institution and living on campus spends $26,590 for one academic year.  The price of tuition and fees for a 4-year institution in 2019 was 2.97 times as high as it was in 1989, after adjusting for increases in the Consumer Price Index.  Meanwhile, median family income was only 19% higher in 2018 than it was in 2008.  The College Board also reports that of the 2015-16 bachelor’s degree recipients, only 41% completed their degrees within four years of first enrolling in college.  No wonder we often hear that there is a student debt crisis!

            When wearing my financial planner hat, I would advise the parents of a newborn child to start saving money for college by depositing certain prescribed amounts into a Section 529 Savings Plan.  There are many reasons for this, which this article will explore, but it is important to note that 529 Plans are not only useful for new parents, but also for grandparents (or great-grandparents) who know they want to help defray the cost of higher education for their loved ones but are not sure how to go about doing so.

            529 Plans take their name from Section 529 of the federal tax code which exempts a qualified tuition plan from income taxation.  These qualified tuition plans are administered by the 50 states and the District of Columbia.  Under a 529 plan, the account owner, depending on the state’s program, can either pre-pay for tuition in today’s dollars for their intended beneficiary or set aside cash contributions into an account designed to pay for education expenses for the beneficiary at a future date.  Because only a handful of states still offer the prepaid tuition option, the type of 529 Plan referred to in this article will be the straightforward investment account.

            The benefits of saving for college within a 529 Plan is income tax deferral, much like with an IRA, and tax-free withdrawals.  Specifically, when funds are invested in a 529 account, any interest, dividends and gains that are earned on those funds will not be taxed if the funds remain in the account.  Further, when the funds are withdrawn, there is no income tax due if the withdrawn funds are spent on “qualified education expenses.”  These expenses include enrollment fees, tuition, certain room and board expenses for on-campus students, certain rent, food and utility bills for off-campus students, computers, software, internet access, qualified education loan payments up to $10,000 per designated beneficiary, and since the passage of the Tax Cuts and Jobs Act in late 2017, up to $10,000 per year for private primary and secondary education tuition.

To illustrate the long-term value of using a 529 Plan to save for education expenses instead of a taxable investment account, I will use the example of a child born in 2021.  If that child attends a public, in-state, 4-year college or university, that child will have to accumulate approximately $334,000 by the time she is 18 years of age.  To achieve this goal, assuming an average annual rate of return on an investment portfolio of 5.65%, that child’s parents or grandparents would have to save $625 per month to a 529 Plan versus $704 per month to a taxable account.  Similarly, a lump sum of $114,428 deposited into a 529 Plan today would yield the same results as a lump sum of $141,140 deposited into a taxable account.

To set up a 529 Plan, one would typically speak with a financial advisor or visit the website of the state plan they wish to utilize.  The person setting up the account would be considered the owner and the owner would choose a beneficiary – the person for whose benefit the funds are being set aside.  Once the account is established, the owner will need to choose an investment portfolio.  Many state plans offer Target Date portfolios based on the anticipated year of the beneficiary’s enrollment.  The farther away the beneficiary’s enrollment date, the more aggressive the portfolio will be.  This means that the overall asset allocation will lean heavily towards stocks, which are considered riskier than bonds or other fixed income investments.  As the enrollment date gets closer, the portfolio will automatically shift to more conservative allocations to protect the investment.

With the overview of 529 Plans behind us, let’s turn our attention to how individuals can use them as part of their estate planning strategy.  The federal tax code limits how much we can give away.  As of 2021, every taxpayer can give away up to $11.7 Million during their lifetime and at death without incurring an estate or gift tax.  This number is scheduled to be reduced to approximately $6 Million unless changes are made to the tax code prior to 2026.   Additionally, every taxpayer can make annual gifts of $15,000 per year per recipient without reducing their lifetime exemption and without having to file a gift tax return.  For example, if you are married and have three grandchildren, you can gift a total of $90,000 in one year – $15,000 from each spouse per grandchild.  Even better, with 529 Plans, an individual can elect to fund five years’ worth of annual gifts, or $75,000, to one 529 Plan in one year. 

If the beneficiary never attends college, the client has a couple of options.  Most simply, they can change the beneficiary of the 529 Plan.  Doing so does not cause a taxable event.  On the other hand, if there are no other desired beneficiaries, they could withdraw the funds, which does cause a taxable event. In that case, the earnings portion of the distribution must be reported on the account owner’s federal income tax return and is subject to income tax and a 10% penalty.

ASK ANYA

HOOK LAW CENTER: Anya, is it true that cat owners can tell what their cats are trying to tell them by just looking at their tails?

ANYA: Yes! Your cat’s tail is one of their most expressive body parts! If your cat is calm and happy, their tail will be upright, sometimes moving back and forth slightly.  On the other hand, if they are angry, their tail will be swishing back and forth very quickly, which many people often associate with happy behavior.