The benefits and misconceptions of 529 plans: A Q&A with Richard Rosen

Image

As a University of Arizona employee, you most likely know about the substantially reduced tuition rates available to employees eligible for full benefits, their spouses and dependents, retirees and certain affiliates.

You probably also know that tuition is only one piece of the college finance puzzle.

A qualified tuition plan – often referred to as a 529 plan – can be an effective savings tool for many families, regardless of income, age or financial aid status. Variations of these savings plans originated on the state level and earned federal recognition when Section 529 was added to the Internal Revenue Code in 1996.

The Arizona Board of Regents contracts with both Fidelity Investments and TIAA to provide the Optional Retirement Plan and Voluntary 403(b) Plan. As part of these contracts, both investment companies offer a variety of financial education resources to all employees whether or not they have accounts with them. Employees can meet with a certified financial planner from Fidelity Investments or TIAA to review their personal financial situations and plan for future financial needs – including saving for college.

The plans are special savings accounts established specifically to save funds for education-related expenses. Each plan has an owner who is in charge of the investments, which – depending on the state or the specific plan – can be started for as low as $15 or $25 per month. Most 529 plan owners elect to set up automatic monthly contributions that are directly transferred from a traditional checking or savings account. A 529 plan can be set up at any time, and there is no limit to the number of 529 plans an individual can establish.

Arizona residents can take part in the state-sponsored Arizona Family College Savings Plan, or they can set up a 529 plan through Fidelity. Financial advisers at many major banks can also work with individuals who are looking to create a 529 plan.

Lo Que Pasa spoke with Richard Rosen, interim director of the Take Charge America Institute for Consumer Financial Education and Research in the Norton School of Family and Consumer Sciences, to explain the primary benefits of 529 plans, some common misconceptions and ways in which college shoppers can properly evaluate these plans.

What are some of the biggest benefits of starting a 529 plan, compared to starting a regular savings account for college expenses?

Although contributions to a 529 plan are not deductible, any earnings in a 529 plan grow federal tax-free, and will not be taxed upon the withdrawal of monies for qualified expenses. In addition to the federal income and capital gains tax savings, more than 30 states currently offer a full or partial income tax deduction or tax credit for contributions made to a 529 plan.

Another tax advantage: Contributions to a 529 plan do not have to be reported on your federal tax return. Until such time as withdrawals for qualified educational expenses are made from a plan, there is no requirement to report taxable or nontaxable earnings. Moreover, in 2020, deposits to a 529 plan up to $15,000 per individual per year – $30,000 for married couples filing jointly – will qualify for the annual gift tax exclusion. This will eliminate the need to file Form 709 with the IRS.

With regard to comparing assets within a 529 plan to such financial assets as funds in a regular savings account, a 529 plan is a very hands-off way to save for education. At the same time, it provides the means for equity and income investment opportunities not afforded a standard savings account.

What are some common misconceptions surrounding 529 plans?

You will not lose unused money in a 529 plan. There is no requirement to forfeit the extra assets in a 529 plan. The remaining money can be used for postsecondary education. It can also be used for another beneficiary who is a qualified family member, such as younger siblings, nieces, nephews, grandchildren or even for yourself. You can withdraw the amount of any scholarship awards from your 529 without penalty. However, it is important to realize that federal and state income taxes on the earnings still apply. If you need to take a withdrawal for expenses not related to education, you may owe taxes on the earnings withdrawn, as well as a 10% penalty. Distributions from 529s are made up of contributions and earnings in proportion to their levels in the account. That means that the portion of the withdrawal that is made up of your contributions would be tax-free and penalty-free, but the earnings portion would be subject to taxes and the 10% penalty.

You can invest in a plan offered by any state, or your own. You are not required to invest only in your state's 529 plan. Consider your own state plan first, as some states offer residents state tax advantages or other perks such as financial aid, scholarship funds and protection from creditors. The differences between state plans include investment managers and choices, fees and potential state-level tax deductions or credits.

You don't have to be related to the beneficiary on the account to open a 529 account for them. Friends or family members can open a 529 college savings account regardless of their income or relationship to the student – and can even name themselves as the student beneficiary on the account.

More importantly, anyone can contribute. Invite grandparents, uncles, aunts and friends! Keep in mind that if a family member other than the parent opens a 529 account for the student, the student's financial aid eligibility may be affected, depending on when the 529 funds are used.

Do 529 plans have any impact on a student's ability to qualify for financial aid?

There is minimal impact on financial-aid eligibility when using a 529 plan. Unlike assets held in a custodial brokerage account, only 5.64% of the assets in a parent-owned 529 are factored into the Free Application for Federal Student Aid, or FAFSA, which helps determine eligibility for grants, work-study programs and loans. Essentially, an amount no greater than 5.6% of the 529 assets may be included in the Expected Family Contribution that is calculated during the federal financial aid process. As a point of comparison, student-owned assets are assessed at rates as high as 20%.

Are 529 plans different in Arizona than in other states?

Like Arizona 529 plans, all 529 plans throughout the country are directly sponsored by the state. While all states have a state-sponsored 529 plan, some states have multiple plans. As far as investment options for the contributed assets, each state incorporates different investment options for each plan. Accordingly, when a 529 plan account is established, it is critical to decide which state's plan you are going to use. Another possible concern with specific state plans is when a family migrates to another state. If so, they might consider changing their college saving strategy to maximize state income tax benefits in the new state. Depending on the state, they may continue to fund an existing 529 plan or redirect new contributions to a 529 plan sponsored by the state they are moving to.

Can 529 plans be used to pay for post-graduate education or online courses?

Yes, online and postgraduate education are afforded the same opportunities provided to undergraduate education. Not only is postgraduate education eligible, so are vocational and trade schools and community colleges. With the passage of the Tax Cuts and Job Act in 2017, 529 distributions can be used for elementary or secondary education (public, private or religious), with a contribution cap of $10,000 per student per year to cover tuition. The one caveat is that it must be an educational institution that is eligible to participate in the federal student aid program administered by the U.S. Department of Education.