Reduce fees and taxes to maximize your keep
Broker-sold 529 Savings Plans are much more expensive than direct-to-consumer options
Your state may offer tax incentives on contributions made to 529 Savings Plans
Understand federal and state tax laws to avoid unintended taxes and penalties
The cost of higher education has been on the rise for decades. According to U.S. News, Americans now owe over $1.6 trillion in student loans with the average student owing $34,844. Many new parents understand the challenge of balancing life with student loans and want to help their young children avoid or minimize this challenge by saving for college early. Sallie Mae estimates that 56% of families with children are saving for college, but only 30% of those families are using 529 savings plans.
An education savings goal is great, but the right account can determine when and whether you reach your goals. 529 Savings Plans are built specifically for education savings and offer a variety of benefits, such as:
Tax-free growth for qualified education expenses;
Can be used for K-12, high school, vocational, and college expenses;
Income tax incentives for contributions depending on state residency;
Participation in any state's savings plan, not just your state's plan;
Use savings for education in any state (even abroad), not just in the plan sponsor's state; and
Update the beneficiary (student) at any time.
While all 529 Savings Plans generally operate under the same guidelines and offer similar benefits, we want to highlight some differences between plans and key considerations to finding the right plan to maximize your keep.
Know Your Fees: Broker-Sold vs. Direct Plans
All 50 states and the District of Columbia sponsor at least one type of 529 Savings Plan, but a state may sponsor more than one plan and that’s where it can get confusing.
A state may sponsor one 529 Savings Plan that is broker-sold (expensive) and another that is direct-to-consumer (inexpensive).
For example, Illinois sponsors Bright Directions, a broker-sold plan, and Bright Start, a direct-to-consumer plan. Because these plans are both state-sponsored, they offer similar benefits:
State income tax deduction;
Various investment options; and
Tax-free growth on qualified expenses.
The difference is in the fees, and it’s staggering.
While Bright Start is offered directly to any and all investors, the Bright Directions Savings Plan is a broker-sold plan where brokers can generate commissions for selling the plan and the investments to their clients. These commissions account for the 500%+ mark-up in fees.
Federal vs. State Laws
The Tax Cuts and Job Act of 2017 expands 529 Savings Plans to allow for pre-college education expenses. You are allowed tax and penalty-free withdrawals of $10,000 per year, per beneficiary to pay for K through 12 education expenses, but this allowance is recognized only at the federal level. Some states do not allow for 529 Savings Plans to be used for pre-college expenses, and your withdrawal may be considered non-qualified and subject to state income taxes and penalties.
State Income Tax Benefits
Because 529 Savings Plans are a great way to save for education, you will find private 529 Savings Plan products offered by banks and broker-dealers as a way to increase their assets under management (AUM) and add dollars to their propriety mutual funds.
While these private 529 Savings Plans still offer tax-free growth on qualified education expenses, they typically are more expensive options, and you miss out on any state income tax deductions your state may offer. In order to qualify for any state income tax deductions, your contributions need to be in a state-sponsored 529 Savings Plan.
Tax and Penalties Missteps
While 529 Savings Plans offer the most tax-efficient way to save for education, it is very costly to pay for non-education expenses from 529 Savings Plans.
Any non-qualified education expenses will be subject to taxes on the gains of your investment, plus a 10% penalty. A common pitfall is using funds from a 529 Savings Plan to pay for off-campus living. 529 Savings Plan funds can be used for off-campus living, but the funds are limited to what the school considers the “cost of attendance.” It’s important to work with a school’s financial aid office to understand the “cost of attendance” threshold to avoid paying taxes and penalties.
If you have money remaining in the plan after education expenses, there are a couple of options to avoid paying taxes and penalties:
Change the beneficiary to be another person in your family; or
Keep the balance for potential grandchildren as a part of your legacy plan
An education planning goal is great, but make sure that your education savings strategy complements your overall financial plan, specifically your retirement, before getting started. While other accounts can be used to save for higher education, 529 Savings Plans offer the most tax-efficient way to save for education. Just be sure that you are maximizing your keep by understanding the differences in plan fees, getting your state income tax breaks, and being mindful of any unintended taxes and penalties.
Frank Iozzo, CPWA®
President, Private Wealth Advisor
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