The 4-1-1 on 529 Plans

This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.

It’s safe to say that 2020 uniquely impacted all of us. For some, the year of social distance provided more time than usual to ponder their family’s future. For others, without the ability to spend money outside the home, it left them with excess cash in their pockets, affording them the opportunity to allocate more money toward long-term goals. The changes in savings rates this past year, especially education-related savings, speak to these impacts. According to the College Savings Plan Network, the average 529 college savings plan balance hit a record high as of December 2020. This means that beyond investment gain, more people are now investing in 529 plans than ever before despite the drawbacks of the COVID-19 pandemic. The trend has continued into 2021.

One parent in particular met with us recently to strategize for college funding. By age 10, her first child has shown a clear aptitude for the arts that might take her off the traditional university path; however, our client wanted to prepare for the rising costs of college to keep the door open for this child and her youngest. For her and a whole host of other clients in similar situations, we’ve outlined some pros and cons of investing in a tax-advantaged 529 plan for the future of the children in your life.

Investment plans come with their own sets of pros and cons. A 529 is no different. One of the most important benefits of a 529 plan is tax-free growth. All distributions made from the plan for qualified higher education tuition are also free of federal taxation.

Many states offer a tax break in addition to the federal tax break mentioned above if you use your resident state’s plan.

A little-known fact is that a 529 plan is not limited to college or university costs. Funds from a 529 can also be used for continuing education, trade school, or even student loans, which we’ll discuss in more depth below.

One of the biggest disadvantages of a 529 plan is that not every child will need the funds for higher education, in turn, leaving the funds unused. Unfortunately, unused funds can’t simply be withdrawn without penalties. If you find yourself in that situation, you do have options. You can:

• Wait it out and continue to let the money grow in the hopes your child may pursue higher education in the future.
• Transfer the plan to another qualifying family member.
• Make yourself the beneficiary and use the funds for higher education such as an advanced degree or continuing education program.

Another potential drawback is the limited ability to direct your investments. Most 529 plans offer a platform of investment options including age-based portfolios and some individual index funds or mutual funds. These options may be appropriate for some beneficiaries but don’t allow for much customization.

In 2017, the Tax and Job Cuts Act approved the use of up to $10,000 of 529 plan funds annually for Kindergarten through 12th grade tuition expenses at private, public, and religious schools without federal taxation. Where states either align or don’t charge state income tax at all (here’s looking at you, Washington!), these dollars can be withdrawn tax-free. It’s important to note that several states do not align with this federal tax benefit, California and Oregon among them. In these non-conforming states, there will be state income tax due in addition to repercussions depending on credits or subtractions received for the contributions that are being used K-12 expenses. Since tax implications vary by state, we recommend consulting with a tax advisor prior to any distribution about how tax provisions affect your circumstances.

In addition to grade school and university tuition, 529 plan funds can also fund community college, certificate programs, trade schools, and vocational schools.

Beyond current educational pursuits, you may be able to use 529 funds to pay off existing student loans. The SECURE Act allows up to $10,000 in 529 plan funds to be used to pay off a beneficiary’s student loans free of federal taxation. As with the provision for K-12 expenses, whether or not states align will impact overall taxability, so it’s important to consult a tax advisor before making a distribution for this purpose.

Finally, beyond the cost of tuition, 529 plans can help cover other eligible expenses at a college or university degree program. These include:

• Books that are required for classes
• Computers, printers, and internet service as well as specific software programs such as Microsoft Office and Adobe Creative Suite
• Room and board up to the projected expenses outlined in the federal financial aid package

Investing in a 529 plan is a personal decision. Like any other financial choice, whether or not the 529 is right for you depends on your family’s unique circumstances. That said, their tax-advantaged growth and flexibility make them one of the most powerful tools in the proverbial shed for anyone looking to secure financial stability for future educational expenses.

Before making any major financial decisions, we always recommend connecting with your Aldrich Wealth financial advisor to learn more about your options.