College can be expensive. In fact, tuition inflation over the last decade has averaged 4.635%. Education planning is now a long-term financial consideration for many families and the 529 plan has become the default choice for those that want to save for college.
529 plans are popular because they allow for tax-free growth of the account’s investments as long as the funds are withdrawn to pay for qualified education expenses such as tuition, room and board, and supplies. Some states will even give residents an income tax break if investing in the state’s own 529 plan.
However, other accounts, such as Roth IRAs, also allow for tax-free growth. With more than 1 million fewer students enrolled in college now than pre-pandemic, America’s youth may be on the brink of choosing jobs over college. Since the investments are allocated to education-related expenses only, it begs the obvious question – are 529s the right move for education planning?
No Contribution Limits
One major benefit of the 529 plan is that it does not have an annual contribution limit, unlike other savings methods, like Roth IRAs ($6,000 limit) and UTMAs ($16,000). This allows family members or friends to fund the account and then let the power of compound interest go to work.
One glaring disadvantage of contributing large sums into a 529 account is the potential need to pay gift taxes. However, 529 plans also allow for something known as “superfunding”. This means you can front load up to five years of your annual gift tax exclusion (currently $16,000) all at once. In other words, you and your spouse could each contribute $80,000 per beneficiary without having to pay gift taxes at all.
Flexibility and Control
Another reason why a 529 plan may be better than other education planning methods is the control and flexibility. Unlike Roth IRAs and UTMAs, which must be transferred into the child’s name once they reach the age of majority (either 18 or 21 depending on the state), 529 plan account owners always retain the right to decide who may receive the funds.
When an account owner sets up a 529 plan, they are required to designate a beneficiary, normally a child or grandchild, for that account. The account owner can change that beneficiary at any time as they are the account owner. This type of account prevents the spendthrift possibilities of Roths or UTMAs. Even when the beneficiary turns 18, the account owner continues to have the right to decide whether the beneficiary should receive distributions from the account. This feature can be important for families who are unsure whether their children can be responsible with large sums of money and who are still learning good financial habits.
The ability to change beneficiaries on a 529 also provides flexibility so that the account owner may use the funds themselves. Perhaps a parent wants to get a master’s degree or is interested in attending culinary school. As long as the institution is accredited, the parent has the ability to use the funds for their own education, tax free.
And there’s always the option to use 529 funds for non-education purposes. Granted the distribution will have a 10% penalty and will be taxable, but the money is still available for use.
Another thing that most people don’t realize is that 529 plans can now be used for primary and secondary education expenses and not just for college. Previously parents needed to use Coverdell accounts for tax-advantage education distributions, but the Tax and Jobs Cut Act of 2017 now allows 529 plans to be used for private primary and secondary education expenses, up to $10,000 a year per beneficiary.
Ideal for FAFSA
Changes for the 2023-2024 education year by the Department of Education also makes 529 plans more ideal for federal student aid applications (FAFSA).
Previously, distributions from a grandparent-owned 529 plan to a grandchild would be counted as income to the student and reduce their eligibility for financial aid. But an upcoming rule change eliminates the requirement to report financial help from friends and family. This means that funds from a grandparent-owned 529 plan will no longer negatively impact the students FAFSA application.
For those families whose children may be going to more selective colleges, it is important to note that these universities and private schools also use a second application, called the CSS Profile, which may still ask those questions.
Potential Disadvantages
One area that 529 plans are at a disadvantage compared to other options when education planning is the type of investments available and the frequency in which investment changes can be made. Different states each have their own 529 plan, and each plan will usually have a few specific mutual fund providers to provide the underlying investments. As a result, options will be limited compared to a normal brokerage account.
Another limitation is the number of times a 529 account can be rebalanced or traded. Federal guidelines only allow an account owner to change their investments selections twice a year. This is done in part to encourage a long-term perspective and to prevent frequent trading of an account, but it can be frustrating for individuals that want full control over their investments.
If you’re just beginning education planning, a 529 plan has many advantages over other savings accounts. Still, education planning can be a complex process and 529 plans are not a one-size- fits-all solution. Whether you’ve just begun thinking about your child’s educational future or if you’re ready to commit to a 529 plan, Prudent Investors can help you prepare for the next steps. Schedule a 30-min no-obligation meeting with our team of investment advisors today.
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