College sticker prices have been outpacing core inflation for the last several decades, averaging 3.6% per year for private colleges and 3.7% per year for public colleges (tuition plus room and board) over the last 10 years. This is lower than the 5% per year and 6.6% tuition inflation of the 2000s, but core inflation was higher during the 2000s as well (1). Even if the growth of education costs continues to trend down toward core inflation, it will likely take a paradigm shift and huge reform of the American education system for the growth of education costs to grow (or even decrease) at a slower rate than core inflation consistently. As a result, I believe planning for higher education costs will remain a crucial part of a comprehensive financial plan for the foreseeable future.
There are many ways to plan for future education funding, but the 529 Plan might be the most powerful tool for future education cost planning. It is designed to discourage non-qualified use through income taxes on earnings and a 10% excise tax, and also features the ability to make large contributions and provides tax-free growth when funds are used for qualified education expenses. If funding your child’s education is important to you and you’re financially able to, I believe there’s no better way to achieve that goal than with a 529 Plan account.
Contribute early and contribute often.
Even if you make just one contribution at your child’s birth of $15,000 and never contribute again, after 18 years and assuming an average 5% growth, that contribution would grow to $36,000 completely tax-free. If your spouse also contributed $15,000 at the same time, that final value doubles. Imagine what could happen if you made annual contributions instead of just one.
Regular contributions also get you used to putting money away for a specific goal, create a habit, and break up larger contributions into smaller pieces, so even if you can’t contribute anywhere near $15,000 each now, do what you can now and increase contributions when you’re able to. Leasing or payment plans for big-ticket items are compelling for a similar reason – they create cash flow stability and predictability, introduce a new status quo in your budget, and reduce “sticker shock” by spreading payments over time.
529 contributions count toward the annual gifting exclusion.
In 2020, each donor can contribute up to $15,000 per recipient without having to file a gift tax return (Form 709). Therefore, two parents with two kids can contribute a total of $60,000 annually while staying within the annual gift tax exclusion. Since 529 Plan contributions are considered gifts, plan contributions reduce other gifts that can be given under the annual exclusion and vice versa. You can always contribute and gift more than $15,000 per donor per recipient, but you’ll need to file a gift tax return if you do, and it will reduce your lifetime gift-tax exemption amount ($11.58 million in 2020).
Capitalize on a windfall with a superfunding election.
There’s also the option to “superfund” a 529 Plan account, which allows donors to contribute up to five times the annual limit per child in one year. That’s up to $75,000 per donor per recipient in one year! If you experience a windfall, this is a great way to vault yourself to meeting your education funding goals. Although some states encourage 529 Plan contributions by offering income tax deductions, California is not one of them, so a tax break isn’t a consideration for California residents.
The superfunding election prorates the contribution over the next five years, so you’ll have a limited ability to give gifts to your 529 Plan recipients within the annual exclusion for the next five years. Superfunding a 529 Plan account also requires a gift tax return to be filed to make the election. For married couples, two gift tax returns must be filed if both make the superfunding election, one per spouse. Superfunding can be done at any time, with partial or maximum contributions, and by one or both spouses (or by any other generous person!). Partially superfunding in one year doesn’t preclude you from superfunding again before the five-year proration is done, but gift tax returns and calculations can get complicated.
“Put on your own mask before assisting others.”
529 contributions are removed from the donor’s estate, and while funds can be taken back by the account owner, any earnings on these non-qualified distributions are taxed as income plus a 10% penalty tax. Therefore, you should ensure your own financial stability before starting to fund your child’s 529 Plan account, otherwise, you run the risk of having to make non-qualified distributions and being hit with penalties. We’ve all heard flight attendants say on flights: “put your own mask on before assisting others.” Just as you can’t help other people with their masks if you’ve passed out, you won’t be able to help your children financially if you’re just trying to keep yourself afloat.
Depending on your financial situation, the number of children you have, expected school attended, etc., there are ways to manage the risk of overfunding.
Future uncertainties could lead to a situation where 529 Plan accounts end up being overfunded, and overfunding a 529 Plan account can result in similar taxation and penalty issues. The difference in costs between public and private institutions is already considerable today, and costs 10 to 20 years from now are completely unpredictable – they could become astronomically high or barely grow at all (one can hope). What if your child opts to go to an in-state public institution rather than a private or out-of-state school, or decides to pass on college altogether? As a parent, how can you balance the goal of funding your child’s higher education while managing the risk of under or overfunding?
Changes in the federal tax code now allow 529 Plan accounts to be used for K – 12 tuition payments (up to $10,000 per year, and limited to tuition only), which can help deplete a 529 Plan account if you realize the account is overfunded for future college needs. Some states have not adopted the K – 12 changes, so distributions for K – 12 tuition may be considered non-qualified in your state (consult your tax advisor for guidance).
If you have multiple children, especially if there’s a decent-sized gap in age, one strategy to manage overfunding risk is to prioritize the funding of the oldest child first (unless there’s already a reason to believe they won’t be needing the funds) and continue funding your younger children’s accounts to the extent possible. If your oldest child decides to go to a less-expensive school or not attend college at all, the leftover funds can be transferred to your younger children’s accounts, and future contributions for them can slow or stop altogether.
You can also change the beneficiary to someone else with qualified education expenses. If the original beneficiary has a spouse, children, siblings, niece, nephew, first cousin, certain in-laws, etc. (the list is non-exhaustive) who expect to have qualified expenses, a beneficiary change won’t incur taxes and a penalty. Beneficiary changes to non-family members and certain (mostly distant) family members might be considered a non-qualified withdrawal that incurs income taxes and a penalty, so make sure your new beneficiary qualifies for a non-taxable beneficiary change.
If you ultimately don’t want to transfer the remainder of your child’s 529 Plan account to another future student, you’ll need to accept the ordinary income treatment of the earnings and 10% additional penalty. Otherwise, the funds will be locked in the account and unusable forever. Worse yet, you can’t even donate the unused portion of a 529 Plan account to charity or non-profit institutions (education-specific or otherwise) to avoid the income taxes and 10% penalty. The withdrawal is still non-qualified, and the IRS is unclear on the tax deductibility of a donation of 529 Plan funds – there could be recapture of charitable deductions taken up to the amount of your non-qualified distribution earnings.
There are exceptions to the 10% penalty.
To the extent of scholarships or education tax credits received, non-qualified withdrawals from a 529 Plan account are not subject to the 10% penalty. Attending one of the U.S. Military Service Academies also waives the 10% penalty up to the cost of equivalent education. Finally, death or disability of the beneficiary waives the 10% penalty as long as the funds are sent to the beneficiary, their estate, or heirs in the event of death, or for the beneficiary’s disability expenses in the event of disability. In all of these cases, the earnings are still subject to ordinary income taxes.
Education planning is far from a simple issue to tackle, and the best course of action for you and your family will depend on the other facets of your financial situation. However, securing your current finances first, preparing for retirement and future needs, and then working through education funding with whatever is left is a generally prudent strategy. If you’d like to talk more about your education planning, feel free to send me an email.
1. “Average Published Charges by Sector over Time – College Board.” Research, College Board, 1 Nov. 2019, research.collegeboard.org/trends/college-pricing/figures-tables/average-published-charges-sector-over-time
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