The tax law and education savings

Published 8/12/2018 in The Maryland Daily Record 

(This month’s column will kick off a three-part series on key topics related to personal financial planning.)

In today’s marketplace, 529 plans have become the most popular vehicle to save for education costs. The days of relying on college savings bonds are long gone due to the low interest rate environment. This is coupled with the fact that many families begin saving much earlier in a child’s life due to the increasing costs of attending college. The average college/university annual cost is rising 5 percent a year, which requires college savings to grow over time by at least this rate. We all seem to be scratching our heads about these rising costs and how we will manage, yet each year kids go off to college and we find ways to cover expenses.

Before 529 plans, UGMA/UTMA was the way that money was set aside for minor children. Not without drawbacks, these Uniform Gift/Transfer to Minors Accounts have one fatal flaw when considering the intended goal of setting money aside specifically for education. The key issue is that any money gifted into these accounts is an irrevocable gift that is owned by the minor child. At the age of majority (18-21 depending on the state; in Maryland the age is 21), these assets legally become the sole property of the child to use at their own discretion. Even during his or her lifetime when the child is a minor, the custodian is very limited by how these funds can be used.

While it is easy to draw a line to using these funds for the sole benefit of the child, technically, the minor child could later disagree with how the funds were used. It is an unlikely outcome but one that is a possibility.

Summarized here are the benefits of 529 plans. One key consideration comes when a parent has enough assets to personally fund education expenses out of cash flow; a 529 plan under that scenario may not be an ideal solution as there are some implications if funds are not used in their entirety. However, these plans offer the most flexibility if funds are not completely used for education expenses, so we see 529 plans as the most commonly used vehicle to save:

Tax benefits

Earnings in a 529 plan grow federal tax-free and will not be taxed when the money is taken out to pay for college. As of Jan. 1, 2018, tax-free withdrawals may also include up to $10,000 in tuition expenses for private, public or religious elementary and secondary schools (per year, per beneficiary).

Maryland allows for a $2,500 state income tax deduction per beneficiary per year for plan contributions.

Federal gift tax incentive

Up to $15,000 per year ($30,000 if married filing jointly) is allowed without triggering federal gift taxes. There is a special election that allows a single $75,000 contribution ($150,000 for married couples) as if it were made over a five-year period. This would use up the annual gift exclusion for a five-year period.

Flexibility

The donor remains in control of the account. With few exceptions, the named beneficiary has no legal rights to the funds in a 529 account. This differs from custodial accounts under UGMA/UTMA, where the child takes control of the assets once he or she reaches legal age.

A 529 account owner can withdraw funds at any time for any reason. The earnings portion of non-qualified withdrawals will incur income tax and an additional 10 percent penalty tax, but the funds can come back to the account owner.

The ongoing investment management of the account is handled by an outside investment company hired as the program manager or by the state treasurer’s office. Maryland has partnered with T. Rowe Price.

There are turnkey investment portfolio options that make it easy and low maintenance to handle the investment of funds.

The 529 plan investment options can be changed once per calendar year. Rollover of funds into another 529 plan are allowed one time in a 12-month period. This is meant to allow funds to remain invested without disruption.

There is the ability to change the beneficiary. This allows for funds to move between different beneficiaries as expenses ebb and flow. If one child receives a scholarship or goes to a less expensive school, balances can roll to cover other expenses for another person.

There are plan amount limits per beneficiary. In Maryland, the maximum account lifetime contribution is $350,000. This combines contributions from all sources for a single beneficiary.

Each state determines maximum contribution levels, which vary by plan and range from $235,000 to $520,000.

The best resource that I have found to compare plans and learn more about the specifics of each plan is www.savingforcollege.com.

—Dorie Fain, founder and CEO of &Wealth