Every parent wants the best for their children. This involves providing them with valuable resources and teaching their children how to use these resources effectively. One of the goals a parent has is for their children to enter adulthood feeling financially secure, and making decisions that will positively impact their life. At Shepherd Financial Partners, we believe a 529 plan is an essential tool to use in conjunction with the financial plan. These resources can help assist a family in working towards reaching their many life goals.
Why Invest in a 529 Plan?
529 plans are a tax-advantaged savings plan created by states, state agencies, or educational institutions to encourage saving for future education costs. There are two types of 529 plans: a prepaid tuition plan and an education saving plan. Apart from the well-known tax incentives, there are various other benefits in choosing to contribute to a 529 account.
All contributions made to an education savings plan will be invested in a portfolio of the donors choosing providing the opportunity for potential market growth and compound interest. The most popular investment strategy is the age-based strategy where you can, “set it and forget it”. This is a more passive investment approach to meet education funding goals. Another benefit of a 529 plan is that the donor is always in control of account funds. With a few exceptions, the named beneficiary has no legal rights to the funds. This ensures that the money will be used for its intended purpose. This differs from custodial UTMA/UGMA accounts that grant beneficiaries fund control once reaching a certain age.
What are the Tax Incentives of a 529 Plan?
529 plans offer numerous income tax breaks. Many states offer full or partial tax deductions or credits for contributions. In addition, the federal government does not tax withdrawals from 529 plans for qualified education expenses. This pays off in the long run because the account continues to grow and compound for the account owners’ benefit.
There are instances where some states do not offer significant tax deductions for contributions. In this case, it is smart to shop around for 529 plans outside of the residing state. By widening the search, it is possible to select a 529 account with a solid performance history and low fees.
How to Fund a College Savings Plan?
We believe an appropriate strategy to fund a child’s 529 account is front-loading, also known as super-funding, when the child is born. The IRS has a unique rule allowing the donor to make five years’ worth of contributions at one time, without being penalized with gift taxes. This equates to $75,000 for a single taxpayer and $150,000 if married filing jointly per child.
The advantage of front-loading can be material when compared with regular annual contributions. Front-loading $75,000, for example, if compounded annually will be $180,496 at a hypothetical rate of 5% over 18 years. By contrast, contributing $75,000 over 18 years in annual installments of $4,167 will yield $133,117 at a hypothetical rate of 5%. That is a $47,379 increase at education savings by front loading your contributions and letting it compound over time.
What is an Appropriate Option for Overfunding a 529 Plan?
It is important to consider what to do with excess 529 funds. Families have two main options, to take a withdrawal or save the excess funds for a future use. Here are some strategies for spending leftover 529 plan money:
- 529 plans allow changing the beneficiary to another qualifying family member without tax consequences. Since 529 plans can also be used for continuing education, parents can consider making themselves the beneficiary.
- There is no time limit on spending the 529 plan savings. This creates an opportunity to leave any unused 529 savings as an educational legacy for future generations.
- In some cases, the account owner can take a non-qualified withdrawal without paying a tax penalty on the earnings. This may occur if the beneficiary dies, becomes disabled, attends a U.S military academy, or gets a scholarship.
- For families that have no other use for the money, they can choose to take a non-qualified distribution. Any earnings on the investment will be subject to income tax as well as a 10% tax penalty.
529 plans are an essential tool for a child’s education savings. There are various benefits to utilizing a 529 account such as the state and federal tax incentives, and the many available options for overfunding an account. Our goal is to serve our clients by customizing a strategy based on your financial plan to help maximize education savings and help minimize tax liability. Feel free to reach out to our team for any additional details or questions related to education savings for your family’s long term goals.
Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program.
Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
Investment advice offered through Shepherd Financial Partners, LLC, a registered investment advisor. Securities offered through LPL Financial, member FINRA/SIPC. Shepherd Financial Partners and LPL Financial are separate entities.