As a CPA and a financial advisor, I regularly talk to clients about their interest in passing on a legacy to their children and grandchildren. A 529 plan can be a great way to do that. In this article, I’ll explain what a 529 plan is and the options you can consider for your unique situation.
What’s a 529 plan?
A 529 plan, also known as a Qualified Tuition Program, is a state-sponsored, tax-advantaged savings plan. The intention is to encourage saving money towards and lightening the burden of a beneficiary’s college tuition and qualifying expenses.
There are two types of 529 plans:
1. Education Savings Plan
An education savings plan, the more common of the two options, is paid into by an account holder, typically a parent or grandparent, with the sole intention of easing the financial burden of a beneficiary’s college education expenses.
Qualifying education and expenses include:
- College or university tuition
- Room & board
- Other qualifying costs such as books, computers, and supplies.
Within the past few years, there have been provisions offering alternatives to the way the money can be used. Originally limited to post-secondary education costs, the 529 plan was expanded in 2017 to include K-12 tuition and again in 2019 to cover the costs of apprenticeship programs. When the SECURE Act of 2022 was passed into law, 529 plans were again revised, allowing the beneficiaries to use the money to pay off student loans (up to $10,000) and to fund Roth IRAs (up to $35,000) if there is extra money in the account after all expenses are paid.
Similar to a mutual fund, an education savings plan is a long-term investment that fluctuates with the stock market. Similar to stocks and bonds, there is always a level of risk involved in this type of investment plan. The possibility that the investor might lose value or that the investment may not grow enough to pay for college, needs to be considered. This is why a contributor typically creates a long-term investment strategy with the help of a financial advisor, that is strategically designed to reduce risk the closer the student gets to college.
However, unlike other investments, the 529 plan offers one major advantage. A 529 plan grows tax-deferred and withdrawals are tax free. This means that when the beneficiary goes to college and starts pulling from the account, there’s no tax on the monies they’re taking out (as long as it’s used for qualified educational expenses). This is a major incentive, especially because a lot of the savings may be investment gains.
There are no limits to how much you can contribute and qualified withdrawals can be used at almost any eligible institution in the country, including graduate schools, as well as some overseas educational institutions. If the student pays for their education and has money left over, depending on the 529 savings plan, the money may be transferred to siblings although some states have age restrictions.
The most recent provision for the 529 savings plan, set to take effect in 2024, will allow beneficiaries the opportunity to rollover remaining money from their 529 educational savings plan into a Roth IRA up to $35,000 per beneficiary. Of course there are also other restrictions to be aware of. Some of which include, but not limited to:
- The 529 plan must be open for at least 15 years.
- The Roth IRA must be in the name of the beneficiary of the 529 plan.
- Any contributions made within the past 5 years (and the earnings on those contributions) are ineligible to be moved into the Roth IRA.
It’s important to note that since many states offer variations of 529 savings plans, it’s beneficial to be aware of the allowances and restrictions they have in place. Residency limitations, tax incentives, contributions, and other options become less overwhelming if you seek assistance from a financial professional so that you can maximize the benefits a 529 plan can provide while making your money stretch further.
2. Prepaid Tuition Plans
A prepaid tuition plan allows parents, grandparents, and others to prepay tuition at today’s rates for eligible public and private colleges or universities. The intent is to lock in the tuition costs at a preselected college or university, with today’s rate, while paying for the future the financial burden of college.
With a prepaid tuition plan, the money the account holder contributes is saved in and is set aside in an account. When the time comes for the student to use the money, the plan transfers funds directly to the institution to cover tuition. Expenses can be entirely paid for in one lump sum or in smaller installments.
If the child decides not to attend the preselected college or university, they don’t lose the money entirely. Instead, the plan allows you to use the money to pay for another college and university, but the student won’t get the benefit of guaranteed tuition. Most prepaid plans also allow you to transfer the funds to a brother or sister though age restrictions may prevent transferring to an older sibling.
Unlike the education savings plan there are some limitations. For example, the prepaid plan is more limited than an education savings plan.
Some restrictions and limitations of a prepaid plan include:
- Which colleges and universities the account holder can choose from.
- Where the money can be used. For example, room and board is not covered in this plan.
- Coverage is only for college and does not include elementary or secondary schooling, and apprenticeships.
- There is no opportunity to roll the leftover funds into an investment plan such as a Roth IRA.
- If a family chooses not to use the money at all, or cancel the plan altogether, most plans will give you back your original contribution with a reduction and elimination of any interest earned or in the case of some plans, a cancellation fee.
- There are tax penalties for non-qualified plan withdrawals.
One of the most appealing advantages of a prepaid tuition plan is that it provides parents with peace of mind. Unlike educational savings plans, their investment returns are linked to tuition inflation instead of stock market fluctuations. Instead, parents buy tuition at today’s prices, plus a premium, to avoid increasing college costs and stock market instability. With today’s unpredictable markets, we are seeing how a prepaid plan can be appealing.
It’s also important to note that just like an educational savings plan, a 529 plan grows tax-deferred and withdrawals are tax free.
Comparing Educational Savings Plans & Prepaid Tuition Plans
|Education Savings Plan||Prepaid Tuition Plans|
|Nature of the plan||An account where money is contributed, then invested in a variety of options like stocks, bonds, or mutual funds.||An account where money is contributed and locked in at today’s tuition rates. It is typically backed by a state or educational institution.|
|Risk||The value of the account can increase or decrease depending on market performance and there’s no guarantee of return.||Offers protection from tuition increases, but no opportunity for investment gains.|
|Flexibility||Gives opportunity to decide how the funds are allocated for various educational expenses.||Typically only able to be used for tuition and mandatory fees at predetermined and participating institutions.|
|Applicability||The family can save for education over time, has an appetite for risk, and wants options for how funds are used.||The family locks in a rate, are risk-averse, and are able and willing to commit to a specific institution.|
|Adjustability||Wider range of educational institutions.||Limited by in-state or participating institutions.|
|Tax Benefits||Offers tax benefits such as tax-free withdrawals for qualified educational expenses.||Offers tax benefits such as tax-free withdrawals for qualified educational expenses.|
Though the program is run in all 50 states, it’s important to note that the details of a 529 plan differ on where you live and the type of plan you choose. Before making the purchase from the state, through a broker, or a financial advisor, it’s important to understand the obligation and restrictions of the state your beneficiary resides in.
Should I invest in a 529 plan?
Though opening a 529 plan for your children and grandchildren is always done with the best of intentions, it’s only a feasible goal if you are financially ready.
By entering into the commitment of a 529 plan before you’re ready, could lead to costly implications. Once a plan is opened, there is no opportunity to pull from that account without penalty. If you or the beneficiary tries to take money out of a 529 plan before the beneficiary incurs any qualifying expenses, or for non-qualified reasons, the IRS can assess a 10% early withdrawal penalty on top of paying additional income taxes on the gains your investment has produced.
In order to find whether or not you have room in your budget, there are important steps you must take. First, make yourself and expenses the priority. Eliminate pre-existing debt, assess your finances and then see if they satisfy your financial needs. Next, ensure your retirement portfolio aligns with the lifestyle and goals you’ve intended for yourself. Once all of this is done, take an honest look at how much money and how regularly you can contribute to the plan. Though this is a selfless investment, the only way to do it confidently, is to equip yourself with reassuring data.
If you’re interested in passing on a legacy to your grandchildren that ensures them a continuing education free of financial burden, it’s important to reach out to a trusted financial advisor. A financial advisor does the research and finds the best plan for your unique situation.
At Winthrop Partners, our clients are preparing for their golden years, but also interested in preserving a legacy for future generations. As a trusted advisor, we look out for the well-being of our clients and build a portfolio that aligns with their personal goals. As a fee-only fiduciary, we take pride in helping you work through your options and assist in managing your choices. Whether you need help with retirement planning, investment management, or tax planning, we’re here to help you create a long term plan that works in your best interest.
To learn more about how Winthrop Partners can help you manage your retirement plan and diversify your portfolio, contact us today for your free consultation.
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Thomas Bunting is a Financial Advisor at Winthrop Partners. He has more than 50 years of experience in accounting, financial planning, and tax planning. Prior to joining Winthrop Partners, Tom held the roles of partner, managing partner, and senior partner with a mid-sized CPA firm that provided a full range of accounting, tax and financial planning services.
Tom is a member of the American Institute of Certified Public Accountants, the Personal Financial Planning and tax sections of the American Institute of Certified Accountants, and the Pennsylvania Institute of Certified Public Accountants. He was also a former member of the AICPA governing council and a past president of the PICPA. He earned his BS in Accounting from Temple University.