You’ve heard of Pi Day (3.14), now it’s time to celebrate 5.29 day! May 29th is a reminder for those of us with little ones in our lives that now is a good time to save for their schooling with a 529 College Savings Plan!
According to US News, the average tuition and fees for the 2020-2021 school year for public, in-state schools is $9,687, public, out-of-state schools is $21,184, and for private schools it’s $35,087. You don’t need me to tell you that’s a lot of money. But what if you’re thinking of Ivy League? Well, Yale’s annual tuition is $57,700/year.1 How do you come up with that kind of money without scrimping and striving? Well, no one says you have to come up with all that money, I mean, you can take a loan out for lots of things (college, home purchase, car purchase, etc.) but you can’t for retirement. So let me first say that I don’t promote saving for college at the expense of saving for your retirement. But, once you’ve got that covered, you can turn to a 529 College Savings Plan to help boost your savings.
What exactly is a 529?
A 529 is like a Roth IRA but for school. Already-taxed dollars go into the account, they grow without taxation on the growth and as long as the proceeds are used for an eligible expense, the withdrawals are tax-free! 529 College Savings Plans can be used for college expenses as well as private K-12 tuition. As described above, the money in the account grows on a tax-deferred basis until it is withdrawn. If the funds are used for qualified education expenses (tuition, school fees, books and supplies, and room and board) the gains are federally tax-free! Note that tax-free withdrawals are limited for K-12 expenses to $10,000 per year.
Each state has their own sponsored plan, but despite your home-state, both residents and non-residents are able to invest in any plan. Similarly, the child/beneficiary is not limited to that state’s college offerings. Any investor can buy into an out-of-state’s plan and enjoy all the benefits of that plan with the only exception being state tax deductibility of contributions (that is, if it’s even offered by that plan). There’s more on this later.
What is an eligible expense?
Tuition, housing (room and board), lab fees, books, computers, supplies, and other college-related expenses are considered eligible expenses. Two most commonly questioned expenses are transportation costs and clothing, both of which are not considered qualified expenses. As of 2017 a tax law change came about where some states now consider K-12 school tuition costs as eligible withdrawals (up to $10,000 per year). Wisconsin is one of these states. Most recently, as part of the pandemic relief package in December 2019, funds from a 529 can be used to pay off student loans (limited to a lifetime limit of $10,000).
Tax Details
As previously mentioned, every state has their own state-sponsored plan. Many states offer a tax deduction for contributions made by residents, even if the child/beneficiary is not a resident. The amount of tax deduction varies by state but in Wisconsin contributions of up to $3,380 per child (in 2021) are state tax deductible. Additional contributions are welcome, but not tax deductible right away. Wisconsin has a carry-forward provision that allows you to carry the deduction forward to be used in future years up to the then-current deductible amount.2* What’s more is, the $3,380 deduction is per child/beneficiary, so contributions can be made to multiple beneficiary’s accounts and receive multiple state tax deductions per year. More tax deductibility details are available at http://529.wi.gov/
It’s important to note that sometimes the tax deduction isn’t worth it. Again, it’s just a tax deduction for your state tax return, not a federal deduction. In Wisconsin, if you deduct the maximum annual amount of $3,380 the maximum net benefit on the deduction is only $258.57. Again, that’s because only a maximum of $3,380 per child can be deducted from state taxes where WI’s maximum tax rate is 7.65%. So if your state’s plan is a consistent underperformer, or you have enough assets invested with another firm to reach breaks in their sales charges, there’s a chance that you would net out better forgoing the in-state plan by using an out-of-state plan.
Okay, but you mentioned it’s just like a Roth. Why don’t I just use a Roth to save for college?
Yes, 529s are similar to a Roth in that it is funded with dollars that have already been taxed. But a 529 plan is designed to save for college whereas a Roth IRA is designed to save for retirement. As a result, the definition for a qualified withdrawal is different for a Roth than a 529. A qualified Roth withdrawal is one made after age 59 ½. Only at that point will the withdrawal be both penalty and tax-free. The only slight deviation from that is if Roth withdrawals are used to pay college tuition where the 10% early withdrawal penalty is waived. There is will still be taxation on the growth, though, if you’re under age 59 ½. If you’re planning to only withdraw the equivalent of the contributions you’ve made into your Roth, then this is still a viable option because principal can always be withdrawn without penalty or taxation. Regardless of these pitfalls, there are some features that make the Roth a competitive option for college savings.
First off, the rules are a little different in a Roth IRA. Contributions are limited to $6,000 per year, whereas most 529 plans don’t have annual limits, just total account value limits (which are very high- in the hundreds of thousands). Roth IRAs give you more investment selection freedom as you’re not limited to a menu of choices like the 529 does. A 2020 Journal of Accountancy article argued that Roth IRAs can be a good fit for situations where a high-achieving child’s scholarship equals or exceeds their qualified educational expenses that would otherwise be paid by a 529.3
See the table below from that same article in the Journal of Accountancy.
Possible Strategies
I will share a few strategies we’ve used with clients that might be helpful for you. Of course there are more strategies as well as more detailed nuances that need to be explored if you’re going to get strategic. But none-the-less, let’s dig in.
- Anyone can contribute to a 529 plan. And really, how many more toys do your kids really need? So instead of filling the house with more stuff, ask family members to contribute to the 529 plan for special occasions (birthdays, holidays, and other special days). What’s more is, if they are residents of the plan’s state then they can get a state tax deduction!
- Multiple 529 plans can benefit one child. Sometimes grandparents like to start plans for their grandchildren while the kid’s parents are saving in another plan. This isn’t that uncommon, especially for families where grandparents live in another state. What can be sometimes helpful is that the asset is then owned by the grandparent, so it’s not necessarily a known asset when it comes to applying for financial aid. There are stipulations with this, so it is advised that you seek out an advisor for help to make sure all details are understood, but it can be a nice way of saving for college but yet not hindering the child’s ability to receive financial aid.
- If you’ve been contributing to another state’s plan but you want to receive your instate-plan’s tax benefit, you can do so by rolling over your out-of-state plan to your instate plan. In WI you can rollover an out-of-state plan and all past year’s contributions can be used as state tax deductions on future year’s returns. (Again, due to WI’s carry-forward provision, the tax deductions can be carried forward until the balance of unused contributions have been exhausted.)
EXAMPLE:
- You have a $50,000 out of state 529 account of which $20,000 is all prior year contributions with the remaining $30,000 being gains.
- Rollover the out-of-state plan to the WI 529 plan and deduct the $20,000 in prior year contributions at a current rate of $3,380/year carried-forward in future years until the $20,000 is exhausted!
- Due to recent tax reform in 2017, the WI 529 plan now allows for withdrawals to be made for K-12 private schooling. WI also has a private school tax deduction of either $4,000 or $10,000 per student. WI has a rule that the funds needs to be in the 529 for a minimum of 365 days in order for the tax deduction to be maintained, so if you know your child will be going to private school next year, consider contributing at least $3,380 (the deductible amount) of their tuition cost to their 529 and make sure to have it invested for a minimum of 365 days. Starting on day 366 you can make a tax-free withdrawal of those same funds and not have the deduction be reversed! Note that tax deductions are limited to dollars that were paid out of pocket by taxable funds, not from 529 withdrawals, so be careful not to withdraw too much.
- Similarly to #4, there are federal tax credits available to taxpayers who make payments with after-tax dollars, as long as their earnings are below a certain threshold. That means the credits are only available if payment is not made from a 529 savings plans. These credits include the AOTC (American Opportunities Tax Credit) which is up to $2,500 of the cost of tuition, certain required fees and course materials needed for attendance and paid during the tax year and the LLC (Lifetime Learning Credit) which is worth up to $2,000 per tax return. 5
Many states, including WI, offer both an advisor-sold plan as well as a direct-sold plan. Typically direct-sold plans (529s that aren’t sold by an advisor, but are offered directly to the investor) are usually more limited when it comes to a choice of underlying investments.4 There are many nuances and intricate rules involved with a 529 plan. For these reasons and more, there it’s often beneficial to work with an advisor when investing in a 529 plan. We can go over the rules and the variations so you can make sure you’re making the right decision.
This material is for use with the general public and is designed for informational or educational purposes only. It is not intended as tax, estate or investment advice. Lincoln Financial Advisors and its respective employees, representatives, and/or insurance agents do not provide tax, accounting, or legal advice. Individuals should consult an independent professional as to any tax, accounting, or legal statements made herein.
*Prior state tax deductions or credits may be subject to recapture in the event of a rollover. Fees and other penalties may also apply. Clients should check with their tax or legal advisors.
1 Powell, Farran and Emma Kerr. See the Average College Tuition in 2020-2021. USNews.com. 14 September 2020. https://www.usnews.com/education/best-colleges/paying-for-college/articles/paying-for-college-infographic#:~:text=The%20average%20cost%20of%20tuition,respectively,%20U.S.%20News%20data%20shows.
2 Rotell, Briton. Voya Investment Management 529 Regional Director. Email sent 17 May 2021.
3 Jones, Keith T., CPA, PhD.D and Rebecca Hamm, CPA. Look Before you Leap Into a 529 Plan. Journal of Accountancy. 1 June 2020.
4 Browning, Lynnley. The 529 Puzzle: A College Savings Plan Cheat Sheet for Advisors. Financial-Planning.com. 25 May 2021. https://www.financial-planning.com/news/tax-advantaged-529-plans-are-popular-with-wealthy-investors-who-are-saving-for-their-kids-education-but-they-can-have-their-drawbacks?position=editorial_1&campaignname=FP_weekly_Tax%20Tuesday-05252021&utm_source=newsletter&utm_medium=email&utm_campaign=FP_weekly_Tax+Tuesday%2B%27-%27%2B05252021&bt_ee=c5kZMUGV0%2FR29vRadCL8GUB5kgPUisOnav20Q69rFGc04fht%2FcxKUoUjwwwu7mr%2F&bt_ts=1621958451205
5 Education Credits: Questions and Answers. wwwIRS.gov. 27 May, 2021
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