College Savings: Is a 529 Plan Right for Your Child?

by | Nov 30, 2020

A 529 College Savings Plan could be a great way to contribute to your child’s financial future, but is it the best? Tax-advantaged accounts, like 529s, also come with restrictions and less flexibility to offset their tax benefits. But, a 529 College Savings Plan isn’t your only option in saving for your child.

When a new baby is introduced into the family, it is common for parents, grandparents, relatives, and friends to want to help that child start building a solid financial foundation. Usually, this translates into the parents opening a 529 college savings plan for the child, which could be a great way for all to contribute to the child’s financial future.

However, 529 plans also come with restrictions and less flexibility to offset their tax benefits and it’s important to understand these rules to avoid the potential penalties of breaking them. You should also be aware that 529 plans aren’t your only option for saving for your child’s financial future.

Here are a few things to consider about 529 college savings plans along with some other ways to save for your child.

529 College Savings Plans

The name gives it away, sort of. These accounts are designed for education, although 529 plans do not have to be used for college expenses, but can also be used for K-12 tuition, certain apprenticeship costs, and even student loan payments.1

529 plans are primarily attractive for their tax benefits. At the Federal level, contributions are non-deductible, but earnings are not taxed. If withdrawals are considered qualified, they can be taken out tax-free. At the state level, the taxes for 529 plans are similar but vary state-to-state. Some states even allow for deductibility on contributions.2

Another plus is that anyone can contribute to the 529 plan and without being hindered by income limits, unlike with IRAs or Roth IRAs. While there is no Federal contribution limit, most states have imposed contribution limits between $350,000 and $500,000. Also, any contributions above the gift tax exclusion could trigger gift taxes, so be aware of making larger gifts

What about families with multiple children? A 529 college savings plan provides flexibility for changing beneficiaries if one child does not use all the funds in his/her 529 plan. You can even switch the beneficiary to a parent if the parent decides to go back to school.

And the downside? Funds from a 529 college savings plan must be used for qualified education expenses, and the rules are strict. Earnings withdrawn for non-qualified expenses are subject to a 10% penalty and ordinary income taxes (no penalty is applied on the principal).3

Some examples of qualified education expenses include:

  • Tuition and related fees: Qualified expense for both full and part-time student
  • Room and board: Student must be half-time or more and university will set the off-campus room and board budget, which is the amount that can be paid by a 529 plan
  • Technology supplies: Includes computers, printers, software, laptops, and even internet service
  • Books and supplies: Only books and supplies that are required are qualified expenses

One commonly misunderstood item around 529 plans is the treatment of withdrawals if the student obtains a full scholarship or partial scholarship, rendering all or part of the 529 plan unnecessary. Many think they would be penalized for withdrawals in this circumstance. However, 529 plans allow you to withdraw the exact amount of the scholarship without incurring a 10% penalty (the earnings on the portion withdrawn would still be taxed). 

On the more extreme end of the spectrum, some may simply be bearish on the way the entire college system will work in 20 years from now. With an abundance of information available right at our fingertips, advancing technology, and calls for free college from the politisphere, it’s possible that getting a college education might look much different two decades from now.

Either way, you can see there are both advantages and disadvantages to using a 529 college savings plan. Let’s take a look at a few other options to consider.

UTMAs (Uniform Transfers to Minors Act)

An UTMA is a type of custodial account where assets are technically owned by the minor child but controlled by the parent until the minor becomes an adult. UTMA accounts differ primarily to 529 College Savings plans in that there is no designated purpose for the UTMA account (i.e. it doesn’t have to be used for education).

This flexibility for how the funds are used are the main advantage of an UTMA over a 529 plan. If your child wants to use the money for something other than education, like a wedding, a down payment on a home, or travel, he/she would be able to do so. After all, students can easily get loans for tuition, but not for these items listed.

Contribution limits, or the lack thereof, are similar for UTMAs as they are for 529 plans. There is no annual limit, but gift tax considerations will apply for gifts over $15,000.

The downside to an UTMA when comparing to a 529 plan is that UTMA assets can make it more difficult for the child to qualify for financial aid. UTMA assets are counted as the child’s and 529 funds are counted as the parent’s on the FAFSA form.

UTMAs also offer less-advantageous tax treatment than 529 plans. In UTMAs, the first $2,200 (in 2021) in unearned income may be tax-free, but anything over that amount is taxed at that parents’ tax rate, which may be higher.

Lastly, and perhaps most importantly, an UTMA account will grant full access and authority of the account to the child when the child reaches the UTMA age of majority (usually between 18 to 25). Some parents may consider this a deal-breaker as they could be concerned that the child will spend through the account irresponsibly.

Parent-Owned Brokerage Account

Is there a way to get ultimately flexibility, full control, and not grant full authority at the child’s age of majority? Yes. The parent(s) can simply open a parent-owned brokerage account and earmark funds for the child.

Funds from a parent-owned brokerage account can be used for any purpose at any time. Brokerage accounts taxed each year on unearned income at whatever the owner’s tax rate is. Capital gains tax could apply if assets in the account are sold. (see 5 Tax-Savvy Moves for your Brokerage Account).

With a parent-owned brokerage account, the child would have no control over the account when they reach the age of majority and would only be entitled to control if the parents gifted money to the child or transferred the assets to the child at death via a  Transfer on Death (TOD) designation.

Parents who go this route would have the ability to distribute funds to the child at their discretion for education or whatever the parent deems appropriate. When the parent feels the child is responsible, the parent can gift up to $15,000 to the child per year ($30,000 in the case of a two-parent household).

While this route offers no tax benefits, the tax implications of these accounts are often minimal as the balances of these accounts also tend to be minimal. The parent-owned brokerage account offers maximum control, no contribution limits, and unlimited investment options.

Parent-Owned Roth IRA

For some parents, while contributing to your child’s financial future is a noble and loving act, I would only condone doing so if you, the parent, are saving a sufficient amount toward your own future first. Too often, parents have little to nothing saved for their retirement, but they decide to start contributing to a 529 College Savings plan.

The problem with this is that while students can easily get loans and financial assistance for their education, retired individuals cannot. In fact, without saving enough for yourself, it’s possible that you may be increasing the future burden of your own care onto your children.

If you’re unsure about your retirement progress, or not fully utilizing or contributing to a Roth IRA, you may consider starting with a Roth IRA first. Your after-tax contributions (up to $6,000 per individual in 2020) will grow tax-free and earnings can be withdrawn tax-free after age 59 ½.

So, how does this help your child? If you find that you have sufficient retirement savings when your child is in need of funds for any reason, you will have the option to withdraw your contributions with no tax or penalties from the Roth IRA. Since Roth IRA contributions are made on an after-tax basis, there is no tax or penalty for withdrawing your “basis.”

Even better, if your Roth IRA withdrawals are used for education, then you can take out both contributions and earnings with no penalty or taxes!4

The parent-owned Roth IRA option is synonymous to the instructions we all receive when traveling on an airplane with a child. If the oxygen masks come down, put yours on first so that you can help your child. If you pass out from oxygen deprivation, you’d obviously be unable to help yourself or your child.

On the downside, income limits could pose a problem for a parent-owned Roth IRA. In order to fully contribute to a parent-owned Roth IRA, a married couple cannot exceed $196,000 (in 2020) in modified adjusted gross income ($124,000 for single parents).

Custodial Roth IRA

Another outside-the-box idea for helping your child financially is to open a custodial Roth IRA. A custodial Roth IRA is ultimately owned by the child but held in custody by the parent until the child reaches the age of majority. Once that happens, the control of the account is transferred to the child. This setup is similar to the UTMA account, but with Roth IRA rules.

A custodial Roth IRA could be a great way to get the child started very early on their retirement savings. And, the power of compound interest over an extra 10 or 20 years could have a significant long-term result.

The kicker with a custodial Roth IRA is that the child must have earned income to contribute to it. Along those lines, the contribution limit per year for Roth IRAs is $6,000 (in 2020). As far as college savings is concerned, the child can still withdraw money from their Roth IRA for college expenses with no penalty or interest. 5

Bottom Line

There are several ways to help a child start an account for the purpose of college savings or perhaps other potential uses as well. Each option has its pros and cons and your choice should ultimately be based on what your end objectives are.

Some parents are highly committed to using the funds in the child’s account for education. Others prefer to have more flexibility in how the account could be used. If more flexibility is your main objective, then there are better accounts to use than a 529 college savings plan.

You also must consider things like tax implications, control of the account, how will money ultimately be transferred to the child, and when that transfer occurs. But, once you narrow down what your objectives are, your decision should become much clearer. Plus, why not consider a combination of the accounts mentioned above?

For specific advice or help deciding what account you should choose, seek help from one of our qualified advisors or search for a CERTIFIED FINANCIAL PLANNER™ professional so they can help you sort through and navigate your options.

 

Sources

  1. Fidelity.com; What is a 529 Plan?; https://www.fidelity.com/529-plans/what-is-a-529-plan
  2. Nerdwallet; 529 Plan for College Savings; https://www.nerdwallet.com/blog/investing/529-plans-list/
  3. Nerdwallet; 529 Plan Rules: What You Need to Know; https://www.nerdwallet.com/blog/investing/529-plan-rules/
  4. Investopedia; Can My IRA be Used for College Tuition; https://www.investopedia.com/ask/answers/082515/can-my-ira-be-used-college-tuition.asp
  5. Schwab.com; Custodial IRA; https://www.schwab.com/ira/custodial-ira
Joe Allaria, CFP®

Joe Allaria, CFP®

As featured in The Wall Street Journal, USAToday.com, CNBC.com, Nasdaq.com, and Yahoo Finance.

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