If there are children in your life you plan to help pay for college, you have probably heard about 529 college savings plans. While there are other ways to save for the payment of education costs, the 529 plan is the most attractive. Let’s review why.
The 529 plan originates from a section of the Internal Revenue Code which was added in 1996. It authorized the use of these accounts to pay for qualified tuition without the payment of taxes on the gains inside these accounts. For example, if the account owner invested $100,000 in a 529 account and began taking funds from it some years later when its value was $150,000, the gain of $50,000 could be withdrawn (along with the $100,000 principal investment, of course) with no federal tax, if the funds were used to pay for “qualified higher education costs.” To be clear, there is no federal taxation currently (i.e. during accumulation) or upon withdrawal of the growth in value of the account.
The definition of qualified higher education expenses has been expanded several times over the years to include expenses that range from laptop computers to K-12 tuition.
Types of Plans
There are two basic versions of a 529 plan: a prepaid tuition plan, and the more common college savings plan. We will devote our attention to the latter.
Most states offer one or more 529 plans. Some of these plans are sold by investment brokers. Other are offered directly by the sponsoring institution. In Oregon, the advisor-sold plan is sponsored by the Oregon 529 Saving Board and managed by MFS Fund Distributors. The direct plan is sponsored by the Oregon 529 Saving Board and managed by Sumday (a subsidiary of BNY Mellon). In California, the direct plan is ScholarShare 529, which is sponsored by the ScholarShare Investment Board and managed by TIAA CREF Tuition Financing.
Many, but not all, states offer a tax benefit for state residents contributing to the state’s 529 plan. In Oregon, residents may receive an income tax deduction for contributions of up to $4,865 for joint filers (and $2,435 for single filers). If we assume a 10% state income tax rate, that deduction is worth $486 for a couple (or $243 for single filers). California, unfortunately, does not offer a deduction for contributions to its (or any) 529 plan.
Contributions into a 529 account are treated as gifts for tax purposes. A person may gift up to $15,000 into a 529 account without tax consequences. It is possible to “super-charge” a 529 account by bunching gifts into it. Specifically, you may make 5 years of gifts – or $75,000 (5 x $15,000) – into a 529 account in one year. However, it will not be possible to make tax-free gifts in the subsequent four years.
529 plans offer a variety of investment options. Age-based investment options are packaged portfolios that have risk characteristics that are directly related to the age of the student/beneficiary. As the beneficiary gets older and closer to college, the portfolio will automatically rebalance into an ever-more conservative asset allocation. So, a newborn would have an age-based investment account that would be very aggressive, as that child will not be entering college for 18 years. Alternatively, an 18-year-old senior in high school would have an account with a much more conservative allocation. In fact, it would typically have no exposure to the stock market.
A static investment option is characterized by an asset allocation that does not change over time. These options are offered based on the degree of investment risk (i.e. conservative to aggressive), their exposure to markets (e.g. US stocks, international stocks, etc) or based on some kind of environmental, social, or corporate governance screen.
Investors may also have access to a broad menu of funds similar to that found in a robust 401(k) or 403(b) retirement plan. The account owner can build a portfolio using these funds in an a la carte manner.
The Oregon 529 plan offered directly by the state has experienced several changes in management/administration over the years. We will write about the current state of the plan in a future post.
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