Look before you leap into a 529 plan

Parents often wonder how to pay for college as soon as their baby arrives. To prepare for this daunting expense, some families want to start saving early for higher education. One savings option, referred to as a 529 plan after Sec. 529 of the Code, has become increasingly popular. In 2018, the total investments in 529 plans topped $328 billion (see “College 529 Savings Plan Balances Hit an All-Time High,” by Jessica Dickler, CNBC, Sept. 25, 2018).

The basic provisions and benefits of 529 plans are well documented; less understood, however, is whether they are always the best option. These plans began in 1996, and the average traditional student currently attending college was likely born between 1997 and 2001, so most investors may still be saving without thinking seriously yet about fund withdrawals. Would some of them have made a different choice for their savings? Would a Roth IRA be a better option for someone making the decision today? This article summarizes the basic provisions and addresses some important yet often overlooked questions about 529 plans. The information may be useful for many who are currently deciding and for those who provide financial and tax planning advice.

BASIC PROVISIONS AND BENEFITS

The primary benefits of a 529 plan are its relative simplicity and that withdrawals, including contributions and earnings, are generally not subject to income taxes if made for “qualified” expenses. While the Code does not allow deductions for contributions, approximately 30 states allow some deduction for state income taxes (id.).

Another benefit is that the owner may change the beneficiary — with important limitations — if the intended beneficiary dies or otherwise does not use the funds. The money can also be used for trade schools. In 2018, the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, added qualified expenses of K-12 public, private, and religious schools to those of higher education institutions as eligible for tax-free plan distributions (Sec. 529(c)(7), as amended by the TCJA). Then, in 2019, the Setting Every Community Up for Retirement Enhancement (SECURE) Act, P.L. 116-94, added to qualified expenses those of registered apprenticeships, as well as student loan principal and interest incurred by the designated beneficiary or the beneficiary’s sibling, up to an aggregate $10,000 limit over the recipient’s lifetime.

HOW THEY WORK

Once a 529 account is opened, anyone can contribute to it. To make withdrawals, the account owner makes a request through the plan administrator and indicates whether the withdrawal is qualified (discussed later) or nonqualified. The recipient should receive a Form 1099-Q, Payments From Qualified Education Programs, by Jan. 31 of the following year indicating the total withdrawal amount and the portions that are considered earnings versus a return of investment. The earnings portion may be subject to tax plus a 10% penalty to the extent that it exceeds “adjusted qualified education expenses.” The adjusted qualified education expenses equal qualified education expenses minus the amount of tax-free educational assistance and the amount used for the American opportunity tax credit (maximum $4,000 in expenses; maximum credit $2,500).

Example 1: Parent A incurred $9,000 in qualified education expenses in 2020 for her daughter’s education at a university. She covered these expenses partially through a tax-free scholarship of $2,500 that her daughter received and a $5,000 withdrawal from a 529 account. The Form 1099-Q indicates that $2,000 of the $5,000 distribution is of earnings. She claimed $4,000 toward the American opportunity tax credit to receive the maximum credit of $2,500. Her adjusted qualified education expenses are $2,500 ($9,000 − $2,500 − $4,000). The portion of the earnings not shielded by adjusted qualified education expenses is subject to tax; therefore, one-half ($2,500 ÷ $5,000) of the $2,000 earnings is taxable income. Withdrawals for any nonqualified expenses are fully subject to income tax and a 10% penalty. The receipt of a scholarship provides an exception to the penalty portion only, limited to the amount of the scholarship received that year.

FACTORS TO CONSIDER

The definition of qualified expenses can present an unexpected difficulty in many cases. Qualified education expenses of the designated beneficiary include tuition, fees, books, supplies, and equipment; computer or peripheral equipment, computer software, or internet access and related services; and room and board for students enrolled at least half-time (see IRS Publication 970, Tax Benefits for Education, page 58 (2019)). The expense for room and board, however, qualifies only to the extent of the greater of the actual amount charged by the school for living on campus or the allowance as determined by the school in its estimated cost of attendance used for financial aid purposes.

Example 2: Parent J has $25,000 in her 529 account because scholarships have covered all or most of her daughter’s qualified expenses so far. J withdraws $5,000 in 2020 to help toward her daughter’s health and transportation costs; $3,000 of the withdrawal is deemed to be earnings on her Form 1099-Q. If J’s marginal tax rate is 22%, her $5,000 withdrawal will cost her $660 in additional taxes ($3,000 × 22%), excluding any state income tax implications. The unexpected taxes may erode a nontrivial portion of the tax-free growth that she thought she had for 18 years. She avoids the 10% penalty only because of the exemption from the penalty when making a nonqualified withdrawal because the student received a scholarship.

Another item to consider would be the change in beneficiary, which is the only way most 529 plans address what to do with leftover funds. However, this option is limited. According to Publication 970, the alternative beneficiary must be related to the original beneficiary (not the account owner) in one of the following ways:

• Child, stepchild, adopted child, or foster child of the beneficiary or any descendant of them;
• Brother or sister (or stepbrother/stepsister);
• Parent or ancestor of parent;
• Stepparent;
• Nephew, niece, aunt, or uncle;
• In-law;
• The spouse of any of the above; or
• First cousin.

This provision could be a problem for families with only one child or if the youngest child does not need all of the funds for qualified expenses. Furthermore, the answer to the latter question may not be known for many years, leaving the account owner in a state of limbo.

One option, somewhat limited, is the ability to transfer 529 funds to an Achieving a Better Life Experience (ABLE) account for the benefit of the same beneficiary or of a member of the beneficiary’s family (including the beneficiary’s spouse) if that person is disabled. Distributions from these accounts, including earnings, are tax-free if used for “qualified disability expenses” as defined by Sec. 529A(e)(5). Contributions and rollovers to these accounts are subject to limitation based on the amount of the annual gift tax exclusion and, for certain employed beneficiaries, the beneficiary’s compensation.

THE ROTH ALTERNATIVE

For most 529 plans to achieve maximum benefits, the longer assets are invested, the better. Parents and loved ones are not likely to wait until the student is in high school to start funding a 529 plan. However, investment decisions are often a gamble. Could another investment vehicle, such as a Roth IRA, offer many of the same benefits with fewer of the disadvantages? The table “529 Plans vs. Roth IRA Accounts” allows a comparison.

529 plans vs. Roth IRA accounts 

As shown in the table, 529 plans’ primary advantage over Roth IRAs is using earnings tax-free for education before the account owner reaches age 59½. However, while many view a Roth IRA predominantly as a retirement savings product, it can also be more of a “save now, use later” tool. Even those younger than 59½ can withdraw Roth contributions tax-free at any point after the five-tax-year period beginning with the first tax year in which the account owner contributed to the account. Additionally, the earnings may be used penalty-free for certain exceptions such as for first-time home purchases and qualified education expenses before age 59½. So investors can access their earnings for those purposes before retirement age but will still have to pay income taxes on them if they do so before age 59½. After age 59½, investors may make withdrawals tax-free without worrying about incurring a penalty.

There are generally no annual limitations on contributions to a 529 plan, except for gift tax considerations. Since a contribution to a 529 plan is considered a gift, it would be strategic to limit a year’s contribution to less than $15,000 for single taxpayers or $30,000 for married taxpayers to avoid going over the annual gift tax exclusion. If contributors wanted to give more in a single year, they could group the gifts together up to $75,000 ($150,000 for a married couple) and not exceed the limit as long as they gave no other gifts to the same individual in the five-year window. Lifetime contributions on behalf of any beneficiary cannot be more than state-set limits that range from $235,000 to over $500,000. Individuals or couples planning to use a Roth as their primary retirement source may need to consider carefully whether the Roth contribution limits present an unacceptable trade-off.

Roth owners also appear to have a significant advantage when needing to change the beneficiary. As detailed before, there are significant limitations on changing the beneficiary for a 529 plan.

Financial aid is a bit tricky when comparing a 529 plan to a Roth IRA. Applicants include the value of a 529 plan in parental assets, if the plan is owned by a dependent student or his or her custodial parent(s), on the Free Application for Federal Student Aid (FAFSA), but not the value of a Roth IRA. Assets in a plan owned by others such as grandparents or another relative are not included on the FAFSA. Distributions from a plan owned by a dependent student or his or her custodial parent(s) are not included in income on the FAFSA. However, any money distributed from a plan owned by others such as grandparents or another relative and distributions from a Roth IRA in the prior year are included as untaxed income on the FAFSA. According to savingforcollege.com, income has a greater effect on financial aid than does the amount of parental assets; therefore, this may indicate another advantage to the 529 plan for some.

The state where the account owner lives may be a consideration because some states allow deductions for 529 account contributions. For those living in a state with an income tax, such allowances are beneficial in the short term, as long as recapture does not later become necessary due to nonqualified withdrawals. Savingforcollege.com provides information about states that allow deductions, along with other details for comparing 529 plans, including rankings according to fees and performance. The latter could ultimately affect the accumulated balance. If account owners live in a state with no income tax, then they should shop for the plan that looks most attractive, because they do not have to choose their state’s plan. Investment restrictions vary by state, which could also affect the ultimate accumulated balance.

The situation of “leftover funds” discussed earlier seems to be a distinct advantage of a Roth IRA. If the money is in a Roth IRA, the account owner can simply wait until he or she turns 59½ (and the account is past its five-year aging period) and enjoy tax-free withdrawal of any funds in the account, whenever they wish and for whatever purpose. If the funds are needed for education prior to that age, the contributions can be withdrawn tax-free. Withdrawals are not taxed as earnings until the entire principal balance is used up; by contrast, each withdrawal from a 529 plan consists of both a contribution and an earnings portion.

In sum, higher-income individuals or couples may lean more toward 529 plans; incomes beyond a certain level will preclude them from contributing to a Roth IRA. However, many taxpayers for whom college costs are truly a worry may be better off using a Roth IRA.

Example 3: Couple W have a combined household income of $175,000 and dutifully put away $500 per month for their children’s college expenses. They can put the entire $6,000 each year into a Roth IRA. In 18 years, they will have stashed away $108,000 into the Roth IRA. With annual appreciation of 6% compounded monthly, the account balance at that point would be more than $190,000. They can withdraw up to $108,000 even before they reach age 59½, for any reason. After that age, they can withdraw all funds from the account whenever they want, tax-free. If their children all receive scholarships and don’t need the funds, the couple simply have a retirement “windfall” and don’t have to worry about whether the withdrawals are for qualified purposes.

Grandparents who want to give money for their grandchildren’s education should be careful where they put the money. They may receive a tax deduction if their state allows it. If leftover funds are a possibility at all, however, those grandparents may want to consider just giving their children the money to put into their own Roth IRA. For higher-income individuals whose income exceeds the Roth limit, one other option in some cases is a nonqualified deferred compensation plan.

IMPLICATIONS

The decision between a 529 plan and a Roth IRA is not mutually exclusive, of course; taxpayers may choose to put some into both. To a large extent, the issue of whether to take the 529 route is like many other decisions in life, a gamble. If scholarships only cover a portion of qualified expenses and the 529 account covers the remainder with no money left over, the financial part of college should result in a sigh of relief.

The most significant drawback of a 529 plan appears to occur when scholarships equal or exceed qualified expenses or when the child does not attend a university or vocational school. Remember that transportation costs are not included, nor are expenses such as health care and related premiums for the student. Therefore, scholarships could completely negate the benefit of a 529 plan in many instances because they tend to cover some of the most significant qualified costs; this potentially leaves well-intended contributors with a large sum of money that they cannot legally spend without significant taxes and penalties. If others have also contributed to the same account, the account owner can end up in an uncomfortable situation because his or her contributions are commingled with those of others. The other contributors likely did not intend for the official account owner to take funds for his or her personal use. In this situation, there is no truly desirable answer.

Also, although the owner may change the beneficiary, the eligible parties are limited, and risk-averse contributors should consider carefully in the beginning whether they believe there will be a qualified beneficiary, or if this option will even be desirable. Furthermore, changing the beneficiary does not help the original intended beneficiary. Maybe the child receives scholarships and grants. Should that child’s hard work be rewarded by passing their college fund down to a brother or sister? What happens to the investment if the beneficiary decides not to pursue higher education? Again, it cannot be accessed without tax implications.

For those who already have a 529 account and are now reconsidering the desirability of the investment due to scholarship likelihood or other considerations, the change by the TCJA that allows withdrawing 529 funds for K-12 education may prove attractive. Funds withdrawn for nonqualified expenses, and therefore includible in income, should likely be paid to the beneficiary. The Form 1099-Q would then go to the recipient rather than the account owner, who may be in a higher tax bracket. On the other hand, where need-based financial aid is a significant concern, both 529 and Roth IRA owners should research the effects carefully so that they can minimize harm to the beneficiary’s eligibility.

The best way to avoid quandaries is to do as careful an assessment as possible upfront and to maximize options for an uncertain future. For the middle-income taxpayer who has dutifully put away thousands of dollars over 10 or more years, the idea of negating the significant tax benefits they expected is undesirable.

About the authors

Keith T. Jones, CPA, Ph.D., and Rebecca Hamm, CPA, MBA, are, respectively, a professor and senior lecturer in the Department of Accounting and Business Law at the University of North Alabama in Florence.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.

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