For the most part, 529 plans are a great vehicle for saving for college but there is one potential pitfall: if the funds are not ultimately used for college expenses, significant tax consequences could result. Thus I often advise my clients who are establishing a college savings plan to consider other sources of funds to supplement a 529 plan.
For those not familiar, 529 plans were authorized by the Economic Growth and Tax Relief Reconciliation Act of 2001 to provide a tax advantaged savings vehicle for higher education. With a 529 plan you make after-tax contributions, and earnings grow tax deferred and ultimately tax free if withdrawals are used for qualified higher education expenses (tuition, fees, equipment, as well as room & board, for students enrolled more than half time).
Although these plans were authorized by Congress, they are managed by the individual states. While you can invest in the plan of any state, most states provide an incentive for their residents to invest in their own state’s plan by allowing deductions of contributions on their state’s tax return.
Neither New Jersey nor Minnesota, the two states where most of my clients reside, offer a tax deduction for their residents. If your state does not allow a deduction, it pays to shop around for plans with good investment options and low fees and invest directly with the state plan and not through a broker.
The downside to using 529 plans for college savings is that if any of the money is not needed for qualified college expenses for the designated beneficiary, income tax will be due on any earnings withdrawn, as well as a 10% penalty. The 10% penalty (but not the income tax) is waived if the beneficiary dies or is disabled or if they receive a scholarship.
An option for preserving the tax benefit is to transfer the funds into the 529 plan of a qualified relative of the beneficiary which include siblings or step-siblings, first cousins, natural or legally adopted children, parents or ancestors of parents, stepchildren, stepparents, nieces or nephews, aunts or uncles. Just be aware that any contributions to a 529 plan are considered a gift to the beneficiary, and you may be liable for gift taxes for contributions exceeding $14,000 in any given year.
Using IRAs as a Supplement
One way to hedge against the risk of not needing all or some of the 529 plan funds is to use an IRA as a supplement for a portion of the projected college expenses.
Roth IRAs
Taxation for a Roth IRA is essentially the same as a 529 plan. You make after-tax contributions, and qualified distributions are tax free. As a general rule, a distribution must occur after the Roth IRA has been in existence for at least five years, and the withdrawal is made after reaching age 59 ½ to be qualified. Otherwise, earnings are subject to both income tax and a 10% penalty.
But you can always withdraw your contributions tax and penalty free and a withdrawal of earnings will not be subject to the 10% penalty if used for qualified higher education expenses (but will be subject to income tax). What helps is the presumed order of withdrawals. Any withdrawal from a Roth IRA is assumed to be contributions first, then conversions, and finally earnings. Thus you can always withdraw tax free and use for college expenses an amount up to the contributions made while letting the earnings continue to grow tax deferred.
Traditional IRAs
Withdrawals from traditional IRAs are also not subject to the 10% penalty if used for qualified higher education expenses. Of course, all withdrawals from a traditional IRA are subject to regular income taxes since taxes were never paid on monies contributed. Thus your current marginal tax rate will be a factor in whether to implement this strategy.
The advantage of earmarking IRA money for college savings is that whatever is not needed can stay in the account and used later during retirement with no negative tax consequences. This strategy only makes sense, however, if it is planned for in advance as part of your overall retirement plan and not to cover an unanticipated shortfall that could otherwise be covered with loans. You can always borrow for college expenses. You cannot borrow for retirement and would not want to do anything that would jeopardize your retirement.
Using Taxable Brokerage Accounts
Another potential source of funds for college expenses that provides flexibility is a taxable brokerage account. You can greatly reduce taxes paid during the accumulation years by investing in low-cost equity index Exchange-Traded Funds (ETFs) since little if any capital gains will be distributed. You will only have to pay taxes on dividends. The issue with taxes will arise when you need to start liquidating positions to be able to withdraw cash since you will likely have significant unrealized capital gains. Minimizing the tax impact of those capital gains will require careful planning.
As always, feel free to reach out to me at 973-216-8748 or bill@wjlavisors.com if you have any questions.