by Laura Johnson, EA
College is very, very expensive. Qualified Tuition Programs (QTPs), or 529 plans as they are commonly called, help families save for college efficiently. Here’s how your family could take advantage.
- Tax-free income – Interest, dividends, and capital gains are tax-free as they accumulate in the plan.
- Tax-free distributions – No tax on taking money out to the extent of qualified higher education expenses in the year of withdrawal. Qualified expenses generally include tuition, fees, books, supplies, and required equipment. Reasonable room and board also qualifies if the student is enrolled at least half-time.
- Tax-free transfers – You can roll the funds in the plan to another qualified plan for the same or a different beneficiary – so if John doesn’t use all of the funds in John’s 529 plan, the funds can be rolled to Craig’s 529 plan without penalty.
- Flexible contributions – Contributions can come from anyone, so if grandparents or a generous uncle want to contribute, they can.
- State tax benefits – Many states provide a tax deduction, matching credit or other benefit, though frequently only if you invest in that state’s plan.
Still not convinced?
Consider the following. Suppose Dan and Michelle deposit $10,000 into a 529 plan when their baby Ben is 6 months old. After 18 years (assuming no additional contributions), with a 4% annual rate of return, Ben’s plan is valued $20,258 and no tax was paid as the fund grew in value. The family can use that money to pay for Ben’s first year at State U. What if the same $10,000 had been deposited into a taxable savings account paying the same 4% return? Assuming a federal tax bracket of 25% and typical state tax of 5.2%, Ben’s college fund would hold $16,416, or $3,482 less when compared to the 529 plan. And this ignores any state tax benefit claimed in the year of funding the account.
What if Dan and Michelle made an initial deposit of $50,000? Assuming all other variables are the same, the 529 plan will have $101,291 available for college, compared with $82,080 in a taxable account ($19,211 less).
What about gift tax limits?
Gift tax applies once a taxpayer has made taxable lifetime gifts of more than a high limit – more than $5.5M for 2017 and adjusted for inflation. Gift tax and estate tax are linked, and there is no guarantee the current high limits for both will prevail forever. So prudent taxpayers try to avoid making taxable gifts where possible. Contributions to a 529 plan are subject to annual gift tax exclusion limits (currently $14,000 for 2017). However, a donor pre-funding a QTP may elect to take the contributions into account ratably over a period of five years. That is, Dan and Michelle could contribute as much as $70,000 to Ben’s 529 plan in 2017, make the election and the contribution is treated as though they contributed $14,000 for five years, none of which is subject to gift tax. A gift tax return is required in the year of the front-loaded contribution, though no tax will normally apply.
Does a QTP wreck a kid’s shot at financial aid?
Hardly. A QTP owned by a parent is counted in the formula for determining the expected family contribution to the cost of college, but at a low rate compared to other sorts of investments. There are extra twists when a QTP is owned by other than a parent. In that case, the account itself is not considered as an asset available to the student. But distributions from the account ARE considered as such. With clever timing a grandparent-owned QTP can be a great tool for college savings.
Distributions can indeed trigger tax – and, in many cases, a 10% penalty. The tax applies to money not used for qualified higher education expenses of the QTP beneficiary. No tax is due on a return of the initially contributed amounts. With planning, the tax can be minimized or avoided, for example, by changing the beneficiary of the account, or by careful management of the timing of withdrawals.
At John Schachter + Associates we help families plan for college. Let us know if we can answer your questions about qualified tuition programs today!