529 Plans—Better for Grandparents than Parents

College 529 plans get their name from the section of the Internal Revenue Code that defines them.  These college savings plans are a tax preferred “wrapper” for dollars earmarked for education.  Another name for the plans is Qualified Tuition Programs (QTP).  State governments establish and run these plans.

There are two types of QTPs.  The first is the prepaid tuition program.  Generally the prepaid programs permit individuals to purchase college credit hours at current or slightly higher tuition rates for future use.  The choices of schools are limited in the prepaid plans.  The second more widely known QTPs are those that take after tax dollars and provide cash for a beneficiary’s education.  Typically, a parent or grandparent opens the account and makes contributions that grow tax free when used for college.

The person setting up the 529 plan names the person to use the money, the beneficiary.  A plan contributor can name themselves as beneficiary and later change the beneficiary.  There are renaming limitations.  The contributor determines when distributions are made for the beneficiary’s education.

The contributor selects the investments from among those offered.  Organizations that sponsor 529 plans establish the investments offered.  Commissioned stock brokers sell 529 plans and usually are more expense than those sold to consumers directly.  For example, the State of Illinois sponsors three plans.  Two plans are sold through brokers and one sold directly to consumers.  In Illinois, the broker sold plans can have ongoing investment expense ratios over 2% while direct sold plans max out at .69%.  Many states offer a state income deduction for plans setup in contributor’s home state.  Illinois permits an annual deduction up to $10,000 per individual or $20,000 per married couple.

529 plans have a limit to total contributions to the plan ($350,000 in Illinois) and no limit to annual contributions.  The IRS places annual limits in a complex way.  The IRS considers contributions to a 529 plan as gifts to the beneficiary.  Gifts from any one person to another above $14,000 (in 2014) require a gift tax return (but not usually tax).  QTP plans do have a unique tax twist that permit a contribution of up to $70,000 (in 2014) in one year.  This amount doubles for married couples when each partner makes a contribution.  This $70,000 twist permits five years’ worth of 529 contributions in single year and prohibits contributions from the same giver to the same beneficiary for the next five years.  Though there is not tax due, the contributor must file a gift tax return for each of the five years.

Saving for retirement is my recommendation for parents facing the retirement vs. college saving dilemma.  QTPs are tax advantaged only for education and are penalized 10% for non-education use.  Middle income parents are better off maximizing their work place retirement plans and contributing to an IRA before putting money in a 529.  IRAs (Traditional and Roth) share with QTPs the advantage of permitting penalty free withdrawals for education use.  Roth and non-deductible contributions made to IRA can be withdrawn income tax free.  Ordinary income tax applies to Traditional IRA withdrawals.  Money not needed for college remains in the IRA for retirement.  For 2014, the maximum IRA contributions for folks under 50 is $5500 or $11,000 per married couple.

QTPs are great for grandparents that want to help and have their own retirement funding on track.  The limits previously discussed also apply to another little known tax, the Generation Skipping Tax.  The purpose of the Generation Skipping Tax is to keep money from avoiding taxation by skipping a generation.  A skipping example, is money passed from a grandparent to grandchild to avoid estate and income taxes at the parent’s in between level.  Staying below the $14,000 or $70,000 amounts safeguards against this tax.

A unique QTP use for wealthy grandparents is that 529 contributions reduce their taxable estates (amounts over $5.34 million in 2014).  This is unique as the contributor to a 529 plan can also to remove contributions subject to tax and penalty.  Most ways that reduce estate size involve giving up control of their money.  So a grandparent can lower their taxable estate and retain the right to access the money at the same time.

It likely that grandparents will have more grandchildren than parents have of their own children.  While parents can rename a plan’s beneficiary to a child’s first cousin or another related individual, they may not want the money to leave their nuclear family.  Thus grandparents have more practical gifting flexibility in renaming the beneficiary to the cousin (another grandchild) if a particular young adult does not attended college or drops out at some point.

529 plans can be a great tax-advantaged way to help fund a child’s college education.  Most middle income parents should funding their own retirement first.  IRAs provide flexibility for education use while 529 plans do not provide for tax-advantaged retirement use.  529 plans are better for grandparents that already have funded their retirement.

For additional 529 plan information, Savingforcollege.com  and www.collegesavings.org offer excellent information on QTP plans including the ability to do side by side comparisons.

About Rorik Larson

Rorik Larson is a fee-only financial planner located in Palos Heights, IL serving clients throughout the Chicago area and across the country. Essential Financial Strategies provides tax focused comprehensive wealth planning, college planning, and retirement planning, to help clients organize, protect, and grow their assets. Essential Financial Strategies serves clients as a fiduciary.

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