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Providing for Your Children and Others with a 529 Plan

by Forrest Bell, CFP®, President, Financial Planner & Senior Investment Advisor

August 2019

The three biggest financial commitments that most people will make in their lifetimes are buying a home, raising children, and retiring. Of the three, the cost of raising children might be the most surprising. While the cost of a home is easily found on websites such as Zillow.com, the cost of raising children is hidden within the monthly family budget, which makes the cumulative cost even harder to appreciate. Government data, however, has shed some light on this.

Data released in 2018, for example, calculated that the average cost to raise a child in the United States was $233,610 – and that’s just until the child reaches 18. Those in the higher-income range specified by the government – more than $107,400 in gross household income – spend an average of $372,210 raising a child. Notably, these numbers don’t include the cost of college, which Savingforcollege.com estimates will be $323,900 for a four-year private college by 2033. Fortunately, there are tools to help prepare for this cost, and one of the best is a 529 plan.

A 529 plan is similar to a Roth IRA except the 529 plan is specifically designed for education expenses. The positive effect on taxes happens gradually as investments in the account grow: as long as distributions are used for qualified education expenses, you don’t have to pay taxes on what comes out. Hearing this often prompts people to ask about the definition of “qualified education expenses”; they worry that the definition is narrow, but in our experience it’s not. The following education expenses qualify:

Tax-advantaged growth isn’t the only appeal of 529 plans. These accounts can reduce the financial strain of having multiple children in college at once. They also increase the financial flexibility of families that have variable income: Parents with variable income may unexpectedly find themselves unable to pay for all education costs using their earned income alone. The savings from a 529 plan can help make up the remaining costs. Additionally, saving money for education can be motivating in the same way as saving for retirement is. It’s rewarding to know there is a plan in place to pay for something you care about and to track your progress toward your goal. As with most goals, starting sooner rather than later helps – and not just because of compound interest and the tax-advantaged growth. It is generally easier for families to tolerate the adjustment of saving a little extra each month than it is to make a big, sudden adjustment to their spending when expenses such as college tuition emerge.

Here are some common questions our clients ask about 529 plans:

Are there penalties if I withdraw money from a 529 plan and don’t use it for education expenses?

Yes. Distributions from a 529 plan for non-education-related expenses are penalized, but the penalties are not terrible. Remember, taxes are already paid on the money going into a 529 plan, so all that gets taxed is earnings. The earnings on non-qualified distributions are subject to a 10% penalty and income tax.

What if my child’s college education costs end up being less than what I put into my 529 plan?

Our first advice is to wait, because 529 plans can be used for graduate school expenses too. It’s also possible to change the beneficiary of a 529 plan to any of the following family members:

If an older child doesn’t need all of the funds in the 529 plan, you can reassign a younger child as the beneficiary so he or she can use the funds. If none of your children need the funds, you can change the beneficiary to another family member.

If I already have an UTMA (Uniform Transfer to Minors Act) account for education expenses, should I just keep funding that?

Maybe not. UTMAs are subject to the “kiddie tax”, which the IRS instituted to prevent parents from funding UTMAs for tax-avoidance purposes alone. UTMAs generally become the property of the beneficiary when she or he reaches the age of 18 to 21, but some parents consider that to be too young for someone to possess a lot of money with no restrictions on how to spend it. With some planning, it is possible to convert an UTMA into a 529 plan, which avoids giving over such an account to a child too early. However, when a 529 is created through such a conversion, the assets cannot be reassigned to another person if the original beneficiary does not use all of the assets in the account.

Our 529 Plan Services

When we open a 529 plan for a client, we also commit to proper oversight of the account, which includes administering a contribution plan, monitoring the investments, and coordinating the distributions.

There are various ways to contribute to a 529 plan. Some families like to fund it once per year up to the annual gift tax exclusion, which is currently $15,000 per person, per beneficiary. Other families make automatic monthly contributions instead. Clients coming off of liquidity events can “superfund” their 529 plan(s). Superfunding allows the contribution of five years’ worth of maximum gift exclusions all at once. For example, in 2019 two parents or two grandparents could superfund each child’s 529 with up to $150K. While superfunding means no additional contributions can be made over the next five years, all the growth that occurs in that span is tax-advantaged.

We also adjust the investments within a 529 plan up to twice per year as the time horizon to the education goal shrinks. As the beneficiary ages, we shift investments away from stocks and toward bonds. By the time a child enters college, bonds should play a large role in how the funds are invested.

Finally, we coordinate the distributions from the 529 plans themselves. This can occur in various ways. Some parents like to pay tuition with a credit card for the points and then pay off the balance with a distribution from the 529 plan. We can also distribute funds directly to the school. Lastly, we can make the payment to the student. No matter who receives the 529 funds, it’s imperative that the recipient retain receipts that show the distributions were used for qualified expenses.

Though economists and researchers often try to quantify it, the value of an education goes beyond the dollars put in or dollars earned afterward. Education is also an experience, one that helps us form an idea of who we are and what we want to become. Planning ahead for this experience with a 529 plan can make paying for college easier for both you and your student. If you have a child, grandchild, godchild, niece or nephew, or any other young person whose education you’d like to support but you haven’t started yet, ask us about setting up a 529 plan. We manage them for our clients free of charge.

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