According to U.S. News and World Report, the average cost of tuition and fees for 2019/2020 is $10,116 at an in-state public university and $36,801 at a private university. This excludes housing, books, and meal plans, which typically add thousands of dollars. There are many ways that you can save for your children’s or grandchildren’s college expenses, including popular 529 plans, and a variety of factors you should consider as you decide whether a 529 plan is the best option for your family. Some of these considerations may impact your estate planning.
529 Plans: How they Work
A 529 plan, or “qualified tuition plan,” is a savings plan that provides tax advantages to encourage people to save for their children’s or grandchildren’s future education costs. They are known as 529 plans because they are authorized by Section 529 of the Internal Revenue Code, and they are available in every state and the District of Columbia. There are two types of 529 plans:
Prepaid tuition plans. Prepaid tuition plans let you purchase credits for a child’s future tuition and mandatory fees, in advance and at the current prices, helping to avoid paying the higher costs that will be charged by colleges in the future. These plans are usually available only for public and in-state colleges, cannot be used for room and board, and cannot be used to prepay tuition for elementary and secondary schools. Prepaid funds can be applied to tuition at most private post-secondary institutions if a child decides to choose that route.
Education savings plan. These plans allow you to open investment accounts to save for any qualified higher education expenses. Unlike prepaid tuition plans, they can be used for college expenses such as room and board, books, computers, and software. They also typically can be used for any college or university, unlike prepaid tuition plans, which are limited to in-state and public colleges. Education savings plans can be used to pay for elementary or secondary school education as well.
Pros and Cons of 529 Plans
Tax benefits. 529 plans provide several tax benefits:
- 529 plans allow investment earnings to grow tax-free: the longer the funds are invested, the greater the tax benefit you will receive. When you withdraw the money to use it for education expenses or to pay tuition for elementary or secondary schools, the earnings are not subject to federal (and sometimes state) income tax.
- A 529 plan allows you to make five years of tax-gifts in one year per beneficiary. However, no additional gifts can be made to the same beneficiary for five years, and if the donor dies before five years have passed, a portion of the gift is returned to the donor’s taxable estate.
- Some states allow contributions to be deducted from state income tax. This may be limited to 529 plans sponsored by the state in which you are a resident.
Changing your beneficiary. If the child initially named as a beneficiary does not attend college or does not need all the funds in the 529 account, you can name another eligible family member as a beneficiary without any gift or income tax consequences. In addition, no federal generation-skipping transfer tax will be incurred if the new and previous beneficiaries are members of the same generation.
Possible penalties. If withdrawals from 529 accounts are not used for education or tuition, the investment earnings will be subject to state and federal income tax, as well as a 10% federal tax penalty.
Fees. Education savings plans and prepaid tuition plans typically charge enrollment and application fees, as well as administrative, account maintenance, and asset management fees. If you purchase an education savings plan from a broker, that may mean additional fees as well.
Eligibility for need-based financial aid. Money invested in a 529 plan may have an impact on the child’s eligibility for need-based financial aid for college or elementary or secondary school tuition.
Estate Planning Considerations
You’ll need to name a successor. Account owners will need to name both a primary and secondary successor (aka manager), i.e., someone else who can control the account if the owner dies or can no longer make relevant decisions. The successor should be trustworthy since that person will make decisions about how the money is invested, when and how it is used for the beneficiary’s education expenses, and who the new beneficiary will be if a change is needed. The successor will also be able to make non-qualified withdrawals for non-educational purposes. If no successor is named, the new account owner may be decided through trust, probate (if the owner leaves a will), or by operation of law (if no will is in place). Some plans have their own rules of succession and may name the beneficiary as the account owner if the beneficiary is over the age of 18. This may not be ideal if the beneficiary can’t make wise funding decisions. If the beneficiary is not yet a legal adult, the beneficiary’s guardian may be named the account owner.
Consider alternatives. 529 plans have tax advantages, but you can only use the funds for non-qualified purposes if you are willing to pay tax on the earnings plus a 10% penalty. If you may need the funds for retirement or are not sure the child will attend college, consider common alternatives like these:
- Revocable education trust. A special-purpose revocable education trust provides more flexibility. If you set up this trust, you can serve as the trustee and make distributions for the beneficiary’s education, but the trust can also be revoked or revised if you need the funds for other purposes or if the beneficiary does not attend college. This trust will not provide the tax benefits of a 529 plan, but it may work for families who need flexibility. Similar to the 529 plan, a trustworthy individual should be named as the successor trustee.
- Demand trust. A demand trust, also known as a “Crummey” trust, gives parents or grandparents the flexibility to allow the trustee to determine when and how the funds will be used. This type of trust is irrevocable and cannot easily be revoked or revised. Because the beneficiary does not have the right to receive any of the funds held by the trust–except during a brief demand period–the funds held in the trust are protected from claims by the beneficiary’s creditors. In addition, because the beneficiary has the right to receive the gift during the demand period, the funds in the trust are considered to be completed gifts, removing the funds transferred to the trust from the parent or grandparent’s estate. In addition, funds transferred into the trust up to the exclusion amount (in 2019, $15,000) are considered gifts that are free from federal gift tax.
We Can Help
If paying for a child’s college education is one of your estate planning goals, and you are looking for ways to save for those college expenses, we can help you decide which method will work best for you and your family. The strategies listed here are only a few of your options. Please contact our office to schedule a meeting. We can help you create a plan and set your child up for success.