Financial Planning

It’s Graduation Time, and Your 529 Plan is Ready for its Grand Entrance

The education world may be in flux, but higher learning will continue to be a priority for most families – even with a price tag that has outpaced inflation for decades. If a 529 plan is part of the mix of tools you’re using to save and invest, it may be time to think about how you’ll put it to use.

As long as withdrawals from 529 plans are for qualifying expenses, they are not taxed at the federal level. If you take a non-qualified distribution, you will incur income tax and a 10% penalty. Qualified 529 plan expenses include costs required for the enrollment or attendance at a college, university, or other eligible post-secondary educational institution.

Starting in 2018, the definition of qualified higher education expenses for tax purposes expanded to include up to $10,000 per year in tuition for K-12 schools. Qualified expenses include tuition and fees, books and supplies, computers and internet access, room and board, special needs equipment, and student loans. Note that qualified expenses do NOT include transportation and travel costs, health insurance, college application and testing fees, or extracurricular activity fees.

In most cases, however, 529 plans are still used primarily for higher education. And if your child graduated high school this year, those college expenses are no longer some far-off concern. They are front and center, and your investments should reflect that. Due to a shorter investment time horizon, the allocation of the funds in your plan should shift to be more conservative and easier to access when your child is entering college.

If your 529 is managed by AFM, it should be allocated according to our age-based models – which means you’ll already be set up for that change. We prepare for this allocation shift when your child turns 15, moving them to our “15-17 Year Old Model,” which is invested 75% in the American Funds Conservative Growth & Income Portfolio and 25% in the American Funds Preservation Portfolio. If your 529 account is not managed by AFM, you should contact the custodian to ensure you make the allocation adjustments for the shorter time horizon.

Plan ahead to put your 529 into action

It’s also worth considering that your 529 plan may just be one piece of the “paying for college puzzle.” When you have multiple sources that will pay for education-related expenses, it’s helpful to come up with a spending strategy.

The first thing to note is that 529 account funds may conflict with other tax incentives. The two most common tax credits related to educational expenses are the American Opportunity Tax Credit and the Lifetime Learning Credit. The American Opportunity Tax allows families of undergraduates to deduct the first $2,000 spent on qualified education expenses and 25% of the next $2,000. There are income limits to this tax credit, and the credit can be claimed only for 4 years. The Lifetime Learning Credit provides up to a $2,000 tax credit on the first $10,000 of college expenses (with income limits as well), but there is no limit to the number of years this credit can be claimed. These tax credits will not apply to expenses paid for with 529 funds.

If your child has more than one 529 savings account, such as an additional account through a grandparent, knowing which account to use first or how to take advantage of them concurrently could help. Distributions from grandparent-owned 529 accounts may be considered income to the child on the next financial aid application. A beneficial strategy, when available, is to postpone distributions from grandparent-owned 529 accounts to the spring of the student’s sophomore year, right after the most recent tax year on the student’s last undergraduate FAFSA application.

When it’s time to actually access the funds, the exact steps you need to take vary depending on where the account is held. Make sure you are aware of school payment deadlines and the time required to transfer funds from the 529 account to the school. It can take several days for investments to be sold and the proceeds mailed, and then a week or so for the payment to make it to the school and be processed.

The bottom line is that for AFM clients, this is what we’re here for! When you have an upcoming expense that requires drawing on your 529 funds, reach out to our office and we will walk through the process together.

If you have questions about how to maximize your college savings plan, reach out to us.

The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that a college-funding goal will be met. In order to be federally tax-free, earnings must be used to pay for qualified higher education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10-percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.