My last blog post, Know the rules when using a 529 plan, received a lot of feedback, so much so that I decided to follow that up with the 7 frequently asked 529 plan questions.
1. Who can own a 529?
Anyone can own a 529 plan. You can select any beneficiary, including yourself. There is also no limit to the number of 529 plans you may own. You can own multiple 529 plans for the same beneficiary, but they cannot be from the same state.
2. Must I use my own state’s 529 plan?
No, you can select any 529 plan. Distributions can be utilized for any qualified school in any state, and even some foreign schools are qualified.
Some states add tax incentives for residents to use their home state’s 529 plan. Please check with your state to determine if you have an incentive. You can also check finaid.org for a complete list of benefits, if any, for each state.
You also need to research 529 plans, as some are better than others. Sometimes, it’s even better to forego a state tax deduction and invest in another state’s 529 plan. Please examine your state tax situation and the 529 plan carefully. See your fee-only, CERTIFIED FINANCIAL PLANNING™ professional, as you always should, if you have any questions.
3. What if the beneficiary receives a scholarship?
Congratulations, that’s every parent’s dream. You have a few options, including an excellent little bonus option that’s usually unavailable.
First, you can change the beneficiary to any other family member of the current beneficiary. That could be a sibling, step-sibling, first cousin, aunt/uncle, parent, in-law, or grandparent, and most importantly, child (your grandchild). You can change the beneficiary even if there is no scholarship.
The big deal is that a scholarship also gives you a pass go and collect $200 card for the 529 plan. You are allowed to withdraw from a 529 without the 10% penalty. The earnings are still reported as income, though. With a scholarship and an exemption from the 10% penalty, life is good.
You must be careful; you will incur a 10% penalty on earnings. The distribution you take cannot be more than the scholarship amount for the calendar year.
Also, thanks to SECURE ACT 2.0, you can move funds tax-free from a 529 to a Roth IRA. See Know the rules when using a 529 plan to learn more about this strategic option
4. Patience is a virtue
The last option you have is to do nothing. There are no time limits to using a 529. If you think the beneficiary may go to graduate school, you can choose to wait.
It gets tricky if you think you can save it for years and skip a generation.
For example, if the beneficiary is changed from a grandparent to a grandchild, this is considered a gift and could trigger gift and estate taxes. That can easily be avoided by transferring the annual gift tax exclusion amount ($16,000 in 2022) or less. You can do that each year until the entire amount is transferred. If you have more than one grandchild, you could transfer $16,000 to each by opening a separate 529 for each beneficiary.
5. How does a 529 affect financial aid?
529 plans owned by either the student or parent are counted as parental assets and reduce the financial aid by 5.64%. A 529 plan valued at $10,000 would cut aid by $564.
If a grandparent owns the 529, the good news, it is not counted as an asset on the FAFSA form. The bad news, the distribution is counted as untaxed income to the student on the following year’s FASFA form. That could reduce financial aid by 50%.
So if that $10,000 was withdrawn by Grandma, the following year’s financial aid would be reduced by $5,000.
There is an easy way to avoid that problem. If the student is in the last year of school and will not attend another school for at least another two years, wait until the FASFA is completed for the last year, then take the distribution because there won’t be a FASFA form next year. Problem solved.
6. Should I use the 529 for K-12 costs or college?
529 plan funds cover tax-free, of course, K-12 costs, up to $10,000 per student. That applies to public, private, or religious schools. Previously, 529s could only be used to cover costs for college.
529 plans are long-term investments for post-secondary education. Allowing 529s to be used for k-12 costs does go against that. But, and this is a big but, 35 states offer a tax deduction or credit for 529 contributions. If you have children in private school it will benefit you to fund their tuition, books, etc., into a 529 plan. Please check if there is a time limit stating how long a 529 plan contribution needs to be in your respective 529 plan account. If there is no time limit, you can deposit the funds in a 529 on August 1st and pay the tuition bill on August 2. You still will receive a deduction or credit on your state tax return.
7. Is a Roth IRA Better than a 529?
The arguments I hear for using a Roth IRA instead of a 529:
- If the beneficiary doesn’t continue their education, the funds can be used for retirement. Can’t argue with that point, especially if there is no other beneficiary. It would also avoid the 10% penalty on earnings.
- Roth IRAs provide more flexibility on how to invest your funds. That’s a weak argument. There are enough low-cost 529 plans that use index funds and have multiple investment options that flexibility is not a problem.
- A Roth IRA is not counted against financial aid. That is true unless you take a distribution – see below.
The problems I see with using a Roth IRA are:
- The 5-year rule: Withdrawals will only be counted as qualified distributions if the Roth has been opened and contributed to for at least five years.
- Contribution limits: $6,500 ($7,500 if 50 and older) annually. 529 plans have higher contribution limits, currently $17,000 (gift tax exclusion amount per person).
- Income limits: Contributions to a Roth IRA are phased out when your income is greater than $144,000 (filing single) or $214,000 (married filing jointly). The 529 Plan has no income limit restrictions.
- Withdraw limits: There is an education exclusion that will avoid the 10% penalty on withdrawals of earnings. However, earnings will be subject to income tax, unlike those used for retirement after 59 1/2 when distributions are tax-free. The other problem, the withdrawal will be counted as income for the FASFA form the following year.
The bottom line is the 529 outweighs the Roth IRA for the benefits, although in some situations, a Roth may be a good idea in concert with a 529.
There are many other questions and different scenarios for using a 529 Plan. I want to thank everyone who sent in a question. Email me or comment below if you have a question that wasn’t answered.