Use This 1996 Law to Increase Both Your Wealth and the Smarts of Your Family
This is one of the easiest ways to shelter assets for your children or grandchildren… and save a bundle on taxes while doing so.
It varies from state to state, but it – generally – allows you to…
- Contribute money to a special account to invest in stocks, bonds, or money-market funds (and often get a break on your state taxes)…
- Grow your investments tax-free…
- And withdraw the earnings tax-free to pay for qualified higher-education expenses – like tuition, fees, books, computer equipment, and room and board.
It’s called a 529 plan… created by Congress in 1996 as a way for families to invest for college expenses.
All 529 plans are sheltered from federal capital gains taxes… And many states let you deduct your 529 plan contributions on your state income tax return, up to your state’s limit.
Let’s take a look at the most important things to know about 529 plans…
Who should contribute to a 529 account? Anyone…
If you want your children or grandchildren (or nieces, nephews, other family members… or even yourself) to attend college, this is one of the best ways of ensuring that they’ll do so.
A 2011 study from the University of Pittsburgh found that kids who expect to attend college and have a designated college savings account were four times more likely to attend a four-year college than children with similar expectations but no savings.
And anyone can contribute… 529 plans have no income limits, age limits, or annual contribution limits. There are lifetime contribution limits, but they’re in the six-figure range.
Who is in control of the money? You are…
When you contribute to a 529 plan for a family member, you remain in charge of the money.
That allows you to use the money solely for its intended purpose… and you can change beneficiaries at any time, for any reason – just as long as the funds are used for education.
Do you have to use the plan from the state you live in? Nope…
You can open and contribute to any state’s plan. And this competition is a good thing… States continually improve their fund offerings and lower their expense ratios.
Here are the four “gold” plans that Morningstar ranked the highest for 2017: Illinois’ Bright Start College Savings Program, the Virginia Invest529 plan, Nevada’s Vanguard 529 College Savings Plan, and the Utah Educational Savings Plan.
All these plans offer super-low-fee, passive index funds, and also have age-targeted asset-allocation funds that gradually reduce their stock stakes each quarter, so that your risk goes down as you get closer to your goal.
In addition, several state 529 plans offer grants to win your business… like dollar-for-dollar matching or even free money (if you’re born in Maine) just for opening an account. So compare the details before choosing a plan.
You can be a resident of Maryland, invest in a Nevada 529 plan, and send your grandchild to the University of Minnesota (go Golden Gophers!).
And there’s nothing stopping you from having plans in multiple states… You can be a resident of Maryland, invest in a Nevada 529 plan, and send your grandchild to the University of Minnesota (go Golden Gophers!).
Ultimately, you should weigh the tax breaks available to invest in your state’s 529 plan against the investments offered and expense fees. You can view plans state by state by clicking here.
Will it hurt eligibility for financial aid? Somewhat…
Yes, at least a little bit.
Any 529 plans owned by college students or their parents will reduce need-based aid by a maximum of 5.64% of the account value.
So if you have $10,000 in a 529 plan, withdrawn by $2,500 each year, it will reduce aid by roughly $560 the first year, $420 the second year, $280 the third year, and $140 the fourth year – for a total of $1,400.
If you’re a grandparent, your 529 plan isn’t included on your grandchild’s Free Application for Federal Student Aid (FAFSA). However, distributions from the plan are reported as untaxed income to the beneficiary on the FAFSA.
In this case, a $10,000 account balance withdrawn by $2,500 per year would result in about a $500 annual reduction of need-based aid for the second, third, and fourth years – a total of $1,500.
The numbers can get tricky, but there are solutions…
For example, you could simply wait for a student’s senior year of college to take a distribution, because it does not affect aid eligibility for the current award year, only for the subsequent award year. And sometimes it might be worthwhile to take the 10% non-qualified withdrawal penalty if it’s lower than the amount of aid reduced.
What if your family member doesn’t go to college? No problem…
You can use a 529 plan for a lot more than just a regular four-year college…
Your beneficiary could attend a trade or vocational school or participate in a career-training program. And you can also name yourself as the beneficiary and take cooking classes at Le Cordon Bleu or any other interesting school…
For example, Joseph Hurley, founder of the Savingforcollege website, named himself as the beneficiary of his 529 plan at 57 years old to study horticulture at his local community college.
As long as a school offers postsecondary education and its students can apply for federal financial aid, you can use 529 funds for tuition, fees, and qualified expenses. To find out if a specific school or program is eligible, check the FAFSA school search here… It includes 400-plus schools that are outside the U.S. if you wanted to take an educational retirement trip.
It can even be a backdoor estate plan…
Because you can switch beneficiaries at any time, you can start the plan by naming yourself or your child as the beneficiary… then switch generations to your grandchild.
But make sure that you don’t move more than $15,000 per year between beneficiaries – that can trigger gift and estate taxes.
And 529 plans can be a great place to put “extra” required minimum distributions that the IRS requires you to take out from your Individual Retirement Account (“IRA”) or 401(k). If you don’t need the money for your retirement, 529 plans can let you pass it to the next generation.
What about the worst-case scenario?
If there is no one in your family that can use the 529 funds… and you have no interest in continued postsecondary education yourself… you can still get access to that money. It always belongs to you. However, you’ll have to pay federal and state taxes on earnings – plus a 10% federal penalty.
Keep in mind that it is more beneficial to you to max out your 401(k) and IRA before contributing to a 529 plan. Remember… your kids and grandkids can take out a loan for college – but you won’t find any banks willing to give you a loan for retirement.
Dr. David Eifrig worked in arbitrage and trading groups with major Wall Street investment banks, including Goldman Sachs, Chase Manhattan, and Yamaichi in Japan. In 1995, Dr. Eifrig retired from Wall Street, went to UNC-Chapel Hill medical school, and became an ophthalmologist.
Today, he publishes a free daily letter on health and wealth that shows readers how to live a millionaire lifestyle. If you’re interested in more ideas like this essay, you can sign up by clicking here.