February 21, 2018
February 21, 2018
Since their creation in the mid-1990s, Section 529 plans have proven to be a valuable savings vehicle for college education. These plans boast tax-free growth, donor control, and hassle-free administration. Following the biggest overhaul to the U.S. tax code in over 30 years, many investors wondered how 529 plans would be affected by the 2018 federal tax law changes (“Tax Law”). Not only has the new Tax Law maintained the key features that make 529 plans desirable, but it also added a small provision regarding private K-12 tuition that expands their value even further. Though less commonly used, Section 529 ABLE accounts were also positively affected by the new Tax Law (ABLE accounts are special 529 accounts primarily used to help families save for certain expenses associated with raising a disabled child).
What remains unchanged for college savings 529 plans under the new Tax Law is the tax-deferred growth of contributions and the tax-free treatment of distributions used for the beneficiary’s qualified college expenses. Qualified college expenses include tuition, books, fees, supplies, room and board, and equipment required for studying. If a distribution is used for non-qualified expenses, the account holder is required to pay income tax on the earnings withdrawn, along with a 10% penalty.
Under the new Tax Law, account holders may now distribute up to $10,000 annually per beneficiary for tuition at private and religious K-12 schools. In the past, the only other tax-advantaged option that donors could use to fund tuition for K-12 schools were Coverdell Education Savings Accounts (ESAs). Those plans, however, have restrictive limits on contributions. The donor may only contribute $2,000 to an ESA per beneficiary per year, and those contributions must stop before the beneficiary turns 18. Furthermore, unlike 529 plans, ESAs have income phaseouts—the gradual reduction of tax credits based on income—starting at $110,000 for single filers and $220,000 for joint filers. Separately, with respect to ABLE accounts, the new Tax Law now allows 529 plan owners to roll funds over from a 529 plan into an ABLE account without incurring penalties.
Beyond the added benefit of using 529 plan funds for private school tuition, these plans feature lucrative tax benefits. Indeed, contributions grow tax-deferred and distributions for qualified expenses are tax-free. Contributions are not phased out based on income, which is a boon for high-income earners. Further, account owners pay no gift tax on contributions up to $75,000 ($150,000 if filing jointly) per beneficiary if the five-year averaging election—which allows an account owner to treat contributions proportionately over a five-year period—is made when the account is opened. If no averaging election is made, those figures reduce to $15,000 ($30,000 if filing jointly), which are the 2018 gift tax exclusion amounts.
While the tax benefits alone place 529 plans in a league of their own, the degree of donor control available makes them that much more appealing. Upon opening a 529 plan, the donor maintains control of the account, and, subject to a few exceptions, the named beneficiary has no rights to the funds. Most plans allow the donor to reclaim funds at any time, for any use, but the earnings portion of the withdrawal is subject to income tax and a 10% penalty if the distribution is used for non-qualified expenses. In addition to having sole control over the account, the donor does not include assets in a 529 plan in the donor’s gross estate for estate tax purposes. Under certain circumstances, this means that 529 plans can be used as an estate planning tool to move assets outside of one’s estate while still retaining a degree of control if the assets are needed down the road.
Hassle-free administration adds to the list of 529 plan advantages. Once a 529 plan is opened, the management of the account is relatively hands-off. For example, the ongoing investment of the plan is handled by the plan, not the donor. The assets are professionally managed by either the state treasurer’s office or by an outside investment management company, such as Vanguard. One of the best investment options for a hands-off approach is an age-based fund, which epitomizes the phrase “set it and forget it”. These funds begin investing almost entirely in stocks, then gradually transition to investing in bonds as the beneficiary gets closer to attending college.
It’s important to note that while nearly every state offers a 529 plan, not all plans are created equal. When deciding which 529 plan to use, there are some must-have attributes to look for, including 1) an excellent array of investment options, such as age-based options; 2) low costs; 3) high maximum and low minimum contribution limits; and 4) availability of a state tax deduction or credit for in-state residents. Utah’s 529 plan is an example that meets these criteria and more, as the account holder does not have to be a Utah resident to participate. For residents of states like California that do not offer a tax deduction or credit for contributions to 529 plans, the Utah 529 plan may be a viable option to consider.
One other item to mention is that many states, including California, have not yet amended their own tax codes to conform to the new federal Tax Law. Please be sure to verify with your CPA or tax advisor that any distributions from 529 plans for K-12 tuition will not be considered taxable income in your state. If you would like to know more about 529 plans or 529 ABLE accounts and which plan is right for you, feel free to contact a member of your B|O|S team.