Five common 529 college savings plan questions

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1 Advanced Planning September 2013 Wealth Planning Insights Contents Five common 529 college savings plan questions Pages 1 7 Given the historical increases of college costs, families with children are anticipating increased spending for college to continue into the future, and are actively looking for the best strategies to save. Disclosures Page 8 UBS Financial Services Inc. Hando Feldman Adams Group Jason S. Adams, CFP First Vice President - Investments jason.adams@ubs.com 7700 Wisconsin Avenue Suite 300 Bethesda, MD ubs.com/team/hfa Five common 529 college savings plan questions Planning for college has become an integral part of one s overall financial plan. Since 1972, the average tuition, fee, and room and board cost for a four-year private college has increased from $16,611 to $39,518. In the past five years alone, average tuition and fees at public four-year colleges increased by 27% beyond the pace of inflation between the and school years. 1 The average family over the past decade has not come close to keeping pace with the increase in college costs. Given the historical increases of college costs, families with children are anticipating increased spending for college to continue into the future, and are actively looking for the best strategies to save. The projections below help frame the potential future costs families are faced with: Projected four-year tuition and fees 2 Total four-year cost Type of institution Enrolling in 2014 Enrolling in 2031 (18 yrs) Private college $186,581 $427,647 Public college $95,948 $219,914 We address five questions in this article commonly asked when it comes to saving for college.

2 1. How do 529s and other assets impact a student s ability to receive financial aid? Those considering a 529 plan as a tax-advantaged investment vehicle for college savings are often concerned about the impact on financial aid. It is particularly important to consider how ownership and asset type impact the financial aid calculation. Federal aid is needsbased, and the amount a student receives is calculated by taking the cost of attendance (including tuition, books, housing, etc.) and subtracting the Expected Family Contribution (EFC), which is the amount that the student and parents are expected to contribute towards college expenses. Federal aid is needs-based, and the amount a student receives is calculated by taking the cost of attendance (including tuition, books, housing, etc.) and subtracting the Expected Family Contribution (EFC), which is the amount that the student and parents are expected to contribute towards college expenses. Cost of attendance EFC = Needs-based financial aid The EFC is calculated as follows: Parents Income 22% to 47% of available income Assets up to 5.64% of assets 4 mutual funds securities bank accounts, CDs parent-owned 529 plans dependent studentowned 529 plans Students 50% of AGI over $6, % of assets held in student s name UTMA/UGMA accounts Minor trusts Savings bonds The following assets are not included: retirement funds (IRAs, 401(k)s), primary home equity, family-owned businesses, annuities, and insurance policies. 5 Compared to students income and assets, a smaller percentage, up to 5.64%, of parents assets is included in calculating the EFC. Based on this alone, a parent-owned 529 plan is a more attractive option if the goal is to maximize potential financial aid the student will receive. In addition, qualified distributions from a parent or student-owned 529 savings plan are federal tax-free, and are not considered income for financial aid applications under federal guidelines. 6 From the table above, income received by the parents or the student does count towards the financial aid formula. Grandparent-owned 529 plans Grandparents who are well positioned to help fund college education for their grandchildren can receive an additional benefit in contributing to 529 plans, which have the potential to reduce their estate tax liability. In providing a value for their grandchildren, grandparents can also retain control of their assets by funding a 529 plan, in lieu of funding a custodial account or gifting outright. Wealth Planning Insights September 2013 Page 2

3 Using the annual exclusion from gift tax can be an attractive option for those who would like to gift to their grandchildren without impacting their lifetime gift tax exemption amount, currently at $5.25 million for Grandparent-owned 529 plans are not reported as assets on the FAFSA financial aid application. However, if distributions from the grandparent-owned 529 plan are used as financial support for the student, they are reportable on the following year s FAFSA as student income. As most financial aid offices require distributions from grandparent-owned 529 plans to be reported as student income, this can have a significant impact on the student s eligibility for financial aid. Since the income impacts the following year s financial aid, it will not have an impact if the grandparents only fund the final year of college. In addition, some private colleges use a different financial aid form than the FAFSA form. It is called the Parent Profile form. These colleges would require the parents to list any grandparent-owned 529 plans as assets. 7 While 529 plans are advantageous vehicles for higher education saving, it is important to review these vehicles in the context of all assets and income available to the student and the family. If possible, contact the financial aid department to get requirements specific to the educational institution. The decision to fund a 529 plan should be discussed in collaboration with your financial advisor and tax advisor. 2. Should I fully fund a 529 plan? Several factors should be weighed when assessing amounts to be added to a 529 plan. These factors include the family s total asset and gifting situation, the student s income sources and needs, the cost of the college, existing 529 plan balances, and other potential children or beneficiaries within the family. Parents may be reasonably cautious when it comes to funding a 529 plan, in case the 529 plan becomes overfunded, or if the child does not attend college. Beneficiaries When it comes to funding a 529 plan, receiving the tax benefits is contingent upon the beneficiary attending a qualified higher education institution. Withdrawals that do not fall within those rules will be subject to a 10% penalty on the earnings. Parents may be reasonably cautious when it comes to funding a 529 plan, in case the 529 plan becomes overfunded, or if the child does not attend college. 529 plans allow for flexibility in beneficiary selection. The beneficiary can be changed to another member of the family of the same generation, including siblings and cousins, without incurring a tax consequence. A 529 plan for the oldest child of a family could be used to fund expenses of the younger children, mitigating the risk of either overfunding the 529 plan or of penalized withdrawals if the first child does not pursue higher education. In determining whether a 529 plan has sufficient funds or conversely, if it should receive additional contributions, the availability of 529 plan accounts for Wealth Planning Insights September 2013 Page 3

4 other beneficiaries can be an important factor. Gifting is discussed below, but for the beneficiary-change strategy, be aware that it may require the original beneficiary to treat the value of the 529 plan as a gift if the new beneficiary is not at the same generational level as the original beneficiary. 8 If the family only has one child or one possible beneficiary, overfunding the 529 plan means the unused excess is subject to the penalty even if the beneficiary attends college. However, there is no age at which plan withdrawals are not permitted and there are many post-higher education and vocational institutions that are accredited for 529 plan funding. For example, whether or not the beneficiary goes to a traditional four-year college, he/she may also decide to attend culinary school, or take advanced language courses. Any college, university, or post-secondary institution that is eligible for federal aid is qualified for the 529 plan funding. Gifting Another consideration when funding a 529 plan is the gifting situation of the family. Contribution limits in a 529 plan are generous, and many investment programs have lifetime contribution limits above $300,000 per beneficiary. Contributions to a 529 plan, however, are treated as gifts from the donor to the beneficiary. This year, the $14,000 ($28,000 for a married couple) per-donee annual exclusion can be used towards 529 plan contributions. 529 plans also offer the unique 5-year election that allows a contribution of up to $70,000 ($140,000 for a married couple), front-loading the annual exclusion for the following five years. This allows the donor to fund the plan very quickly and maximize the income tax benefits afforded such accounts. 3. Which expenses are qualified distributions from a 529 plan? One of the major benefits of using a 529 plan is the tax-free treatment of distributions when used for qualified higher educational (that is, post-secondary school) expenses. These qualified higher educational expenses include tuition, fees, books, room and board, and include the additional expense of a special needs student at an eligible institution. 9 For part-time students, qualification of certain expenses may depend on other factors such as whether the student is enrolled half-time or more, and the allowable amount set by the school s budget. To be eligible, an institution must qualify to participate in a U.S. Department of Education student aid program. This means that if you want to use the 529 funds for something like a cooking school, whether you can do so depends on what kind of institution is sponsoring it. Wealth Planning Insights September 2013 Page 4

5 Qualified higher education expenses do not include insurance, sports and club activity fees, transportation costs, student loan repayments, and any technology or room and board costs exceeding the cost of attendance financial aid figure. Also, expenses for private school at the pre-college level are never qualified. Expenses for private school at the precollege level are never qualified for 529 plan purposes. In 2013, the IRS expanded the definition of qualified expenses to include the cost of computer technology and related equipment. Prior to 2013, families generally would not be able to use 529 plans to purchase laptops, Internet service, and software. Computers and related services used for educational purposes can now be purchased with tax-free distributions from 529 plans, reflecting the IRS s recognition of the essential tools for those pursuing higher education. Equipment used primarily for entertainment purposes is not considered a qualified distribution from 529 plans. 10 The expansion of qualified distributions from 529 plans to include technology expenses is an additional benefit to using a 529 plan as a savings vehicle for higher education. 4. Should I use a 529 plan sponsored by another state? 529 plans sponsored by your own state can offer considerable tax benefits, most commonly a state income tax deduction. In general, they can offer tax benefits and a variety of offerings in price and investment options. Certain states offer matching grants for those who select their own 529 plan, while other states have tax deductions that apply only for their state s 529 plan. Most tax deductions for investing in 529 plans are capped; for example, in New York, deductions are capped at $5,000 ($10,000 for a married couple filing jointly). States that offer tax credits or matching contributions also limit the tax benefits. A common misconception is that one can only invest in his or her own state s 529 plan. One can invest in a 529 plan from any state that allows non-resident investors. A common misunderstanding of 529 plans is that the plan can only be used for in-state schools. In fact, they can be used for any eligible college, university, and even some foreign institutions. Statesponsored 529 plans each follow the guidelines outlined by the federal government; however, the details of the plan are determined by each state and the sponsors of each plan. It is important to ask these questions when considering a 529 plan in your state: Is there a tax incentive for using my state s 529 plan? How well does my state s 529 plan perform? Does my state offer matching contributions? What are the fees and expenses of my state s 529 plan, and how do they compare to other 529 plans? Another common misconception is that one can only invest in his or her own state s 529 plan. One can invest in a 529 plan from any state that allows non-resident investors. The majority of states allow for this, however, keep in mind that the tax benefits are generally available only for residents investing in their own state s 529 plan. Wealth Planning Insights September 2013 Page 5

6 When considering a 529 plan in college planning, it is important to understand the potential tax benefits of using a 529 plan in your own state prior to making an investment decision. 5. Should I convert an UTMA/UGMA savings account to a 529 plan? A family who has previously established a custodial account under the Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) to save for college expenses might later be interesting in transferring those assets into a 529 plan. Depending on the situation, it may be advantageous to convert an existing UTMA/UGMA account to a 529 plan. However, it is important to consider all aspects of a transfer, including tax consequences, ownership changes, financial aid impact, and beneficiary flexibility. In transferring assets from existing UTMA/UGMA accounts to a 529 plan, there are two potential benefits: improved tax treatment for investment income, and improved financial aid impact. Investment earnings in UTMA/UGMA accounts are generally subject to annual taxes, which can hinder growth of funds for education purposes. Earnings in a 529 plan are not taxed as long as they are in the account, nor are withdrawals taxable if used to fund qualified higher education expenses at an eligible school. In addition, earnings and gains in UTMA/UGMA accounts are taxed to the minor, a taxation sometimes referred to as kiddie tax. The first $1,000 of unearned income is tax-exempt; unearned income over $2,000 is taxed at the parent s rate. 11 The kiddie tax applies to dependents age 18 and younger, and to dependent college students under age 24 with unearned income over $2, A 529 plan must be funded with cash. Any UTMA/UGMA accounts with noncash holdings must first sell and liquidate before transferring those assets to a 529, potentially resulting in capital gains taxes and transaction fees. As previously discussed, UTMA/UGMA accounts are treated as student assets, which are calculated at a much higher inclusion rate (up to 20%) compared to parental assets (5.64%). It is important to be aware of some potential issues with transferring UTMA/UGMA accounts to a 529 plan. In general, 529 plans allow greater flexibility in changing the beneficiary as education funding needs in a family change. However, when a 529 plan is funded with UTMA/UGMA assets, then: The beneficiary cannot be changed. The account retains the original registration as the beneficiary s property, and must be used for his or her benefit. When the child reaches the age of majority (18 or 21 depending on the state), then the custodianship terminates and the child becomes the owner of the 529 account. In transferring UTMA/UGMA assets to 529 plans, one strategy to retain the flexibility of beneficiary and parental control and ownership is to keep non-utma/ugma assets in a separate 529 plan. That way, Wealth Planning Insights September 2013 Page 6

7 UTMA/UGMA assets transferred to a 529 plan will not impact the option to change beneficiaries of existing 529 plan assets. A 529 plan must be funded with cash. Any UTMA/UGMA accounts with non-cash holdings must first sell and liquidate before transferring those assets, potentially resulting in capital gains taxes and transaction fees. Prior to transferring UTMA/UGMA assets, consider that these assets can also be used for other activities and educational expenses before the child reaches age of majority, such as instrument or sports lessons, tutoring services, or summer camp. Although custodial assets are not eligible for the same favorable tax treatment as 529 plans, they may be useful for meeting non-qualified education expenses, such as those listed above. 1 Trends in Higher Education, Tuition and Fee and Room and Board Charges over Time in Current Dollars and in 2012 Dollars. 2 Based on tuition, fees, and room/board costs for school year, College Board, 2012 Trends in College Pricing, costs estimated to inflate at 5% annually. JP Morgan 529, College savings planner. 3 $6,130 is the income protection allowance for academic year. $6,000 is the amount for the academic year. May include distributions from grandparent-owned 529 plans. 4 Assets in qualified retirement plans, including IRAs, are not considered in determining EFC. 5 John Hancock College Savings, 529 savings plans and financial aid. 6 Ibid. 7 Lindroff, David, Back to School on 529s, On Wall Street, July Joseph F. Hurley, CFP, Family Guide to Saving for College. 9 Ibid Joseph F. Hurley, CFP, Family Guide to Saving for College. 12 Columbia Management Education Funding, Considering custodial account consolidation in 529 plans. Wealth Planning Insights features the intellectual capital of UBS in financial planning, estate planning, and philanthropy. Articles are written by specialists in the UBS Wealth Planning and Advanced Planning Groups. These groups consist of professionals with advanced degrees, extensive planning experience, and subject matter expertise, who provide a wide range of planning advice and education to UBS clients. Wealth Planning Insights September 2013 Page 7

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