Congratulations to the Class of 2020! Commencements are looking a little different across the country this year with virtual, socially distant ceremonies. While the graduates’ next steps may be private school or off to college, as parents or family members, you may be wondering the best way to help cover these costs in the current market conditions. Whether you have one of these graduates in your family, would like to start or continue saving for a child in your family, or simply have questions about how best to pay for school, we wanted to take time to help answer some of those questions.
Saving For Education Through A 529 Plan
529 savings plans have traditionally been used to cover qualified education expenses at accredited colleges and universities. The benefit of the 529 plan is that savings deposited into a plan can grow tax-free and, so long as the distributions are used for qualified college expenses, the earnings are also tax-free. In the past, money withdrawn from these accounts that was not used for accredited higher education expenses would be subject to federal taxes on earnings as well as penalties. Thanks to the 2018 Tax Cut and Jobs Act, families in most states can now also use up to $10k per beneficiary per year for K-12 tuition from the 529 plan with no resulting federal taxes or penalties. Please note that there are a handful of states, including California, Oregon, and New York, that still see these K-12 distributions as non-qualified expenses, so account owners can still be subject to state taxes.
Should I Use My 529 Plan To Cover K-12 Costs?
As a general rule of thumb, we recommend using the 529 to first save enough to cover college expenses. This is because the beneficiary will benefit more from compounding years of tax-deferred growth the longer the funds remain invested in the 529. If you find that the beneficiary has an excess amount saved in the 529 or will have college costs covered by another means, then you can look to use the plan to cover K-12 tuition.
What Investment Option Do I Choose?
Investment options vary by each state plan, but in most of the plans Paracle recommends there are typically 2-3 different categories to choose from: age-based, blended, and static allocations.
- Age-based options typically start with a higher concentration of stock when the beneficiary is younger and grow more conservative by adding additional bonds and cash to the allocation as the beneficiary ages.
- Blended allocations offer varying fixed percentages of stocks and bonds to fit the owner’s goals and risk preferences, such as a stock/bond allocation of 80/20 or 30/70. These options may also be called conservative, balanced, or aggressive.
- Static plans allow the account owner to choose from one or more asset classes that do not change or rebalance on their own over time.
Some state plans only allow you to have one type of investment option per beneficiary. Other plans, like New York’s, allow you to have up to 5 investment options so you could mix static allocations along with age-based or blended allocations.
How Often Do Age-Based Plans Reallocate?
Most age-based plans reallocate each year on the beneficiary’s birthday. Some plans reallocate every 2 years. This can be important to pay attention to especially in volatile market periods.
How Often Can I Change The Current Account Allocation?
You will want to check with the specific plan, but most plans only allow two investment changes per account in a calendar year, which is in line with IRS limits. The automatic changes that occur for age-based portfolios do not count.
Which 529 Plan Should I Use?
Each state has its own 529 plan, so the answer varies depending on where you live as well as the quality of the plan. There are over 30 states that currently offer a state income tax credit or deduction for 529 plan contributions. While most states require using their own state plan to receive the tax benefit, there are currently 7 states, including Arizona, that provide residents with tax benefits for contributions to any state plan. In most of these states, anyone who contributes to a 529 plan is eligible for the tax benefit, however, there are 6 states that limit the tax benefit only to account owners and their spouses. States like Washington and California offer residents no state tax deduction for 529 contributions, so residents are free to use any state plan of their choosing.
The state tax incentives can offer a unique opportunity for gifting. As an example, let’s say you live in Arizona and have young grandchildren living in New York. You could gift directly into your grandchild’s NY 529 plan and receive an AZ income tax benefit. You could then gift money to your adult children who could use the money to contribute to their kids’ NY 529 plans and receive a NY income tax deduction.
Aside from tax benefits, Paracle typically looks at the administrative and program fees of the plans, the selection of investment options available, and the underlying expense ratios of the funds when determining which plan is best for a family to use.
Should I Put More Money Into The 529 Plan When Markets Are Volatile?
Whether to put more money into the 529 plan during a market downturn can depend on the age of the beneficiary. When there is a pullback in equities, more equity-focused or aggressive allocations for younger beneficiaries will see the greatest drawdown. The younger the beneficiary, the more strongly we would encourage you to continue adding to the 529 as there is more time for the portfolio to recover and grow. If your plan allows for multiple investment elections and your beneficiary does not need to use money from the portfolio for 10+ years, you may consider combining an age-based option with a static option of diversified equities. Once markets recover, you can then shift the static equity funds back into the age-based allocation.
If the beneficiary is a year or less away from needing to use the 529 funds, rather than invest more in the 529 plan, you might consider keeping the funds in cash to cover the first year or semester of tuition before withdrawing from the 529 in order to give the account more time to potentially recover.
How Do I Withdraw Money From My 529 Plan?
529 plans typically allow the owner or beneficiary to have funds deposited directly into their bank account to cover qualified expenses. You can also elect to have a check mailed to the account owner, beneficiary, or the university where the student is enrolled. You’ll just want to make sure the timing of the distribution aligns with the same calendar/tax year as the qualified expense so they can be properly reported on your tax return.
Can We Help You With Your 529 Decisions?
If you would like to discuss education funding as part of your long-term plan or review your current 529 plan, please feel free to reach out to your Paracle team and we would be happy to help. Email email@example.com or call 206.466.6200 to get started today.
Paracle Personal Financial Management is an independent financial planning firm founded in 2004 with an honest desire to help people optimize their finances by providing unbiased financial planning and investment advice that puts their clients first. Paracle specializes in delivering expert, comprehensive wealth management services to busy families. Their expertise integrates financial planning with investment management to ensure their clients experience confidence in every aspect of their plan so they can focus on what matters most. To learn more about Paracle, connect with them on LinkedIn.