Written by Ben Kirchner, AAMS© / Financial Advisor
There are very few events in life more rewarding than having a newborn child. It’s one of the most exciting and frightening experiences. In the same light, one of the most daunting financial decisions for parents is figuring out how to fund that child’s future. Although there are many unique financial changes that come with children, I want to focus on arguably the biggest one: funding college. There are many layers to this conversation, but for now, let’s focus on one of the key tools used for funding this goal: the 529 plan.
What is a 529 Plan?
A 529 plan is a tax-advantaged investment vehicle that can be used to fund education. It’s primarily designed to fund higher level education (vocational, undergraduate, graduate, post-graduate), but can be used for partially funding private K-12 education as well. These plans are run on a state level by all 50 states and many plans offer a state income tax deduction if you use the state specific plan. However, there are nine states that will give you a tax deduction regardless of the plan you choose. This means if you live in one of the following nine states, you can select any state’s 529 plan and still receive a state tax deduction.
Arizona
Arkansas
Kansas
Maine
Minnesota
Missouri
Montana
Ohio
Pennsylvania
Most 529 plans are going to operate like a 401k or 403b account. You pick from a menu of mutual funds, and they are subject to the ups and downs of stock and bond returns.
Why Would a Doctor Use a 529 Plan?
A 529 plan offers many doctors a state tax deduction on contributions and, as the account is invested, the growth is tax deferred and distributions are tax-free assuming they are used on qualified education expenses. This provides a savings vehicle that is more likely to outpace the inflationary costs of education in comparison to a standard savings account at the bank.
What About Max Funding Limits?
There are no clear maximums to 529 plans like there are with a Roth IRA, 401k, or 403b. That being said, there are plan funding maximums that are state specific, generally between $300-500k.
Many individuals seek to keep contributions under the annual gift tax exclusion limit ($18,000 per person or $36,000 if both spouses contribute). This allows the contributions to remain non-taxable. Third parties can contribute to 529 accounts, meaning both parents and grandparents can all help fund one account on the beneficiary’s behalf. Another option is to frontload the gifts using the “five-year election”- doing up to 5 years of gifts ($90,000) in one year. This requires you to report the gifts on IRS Form 709 for the next five years. This is sometimes called “five-year gift averaging” or “super funding.”
How Are the Funds Disbursed?
If funds are used for qualified education expenses, the funds are distributed tax-free. There is a broad scope of schools that funds can be used for (university, trade schools, etc) and you can search qualifying schools specifically on the Federal Student Aid website.
Many international schools qualify as well.
While there is a $10,000 per year per child limit, 529 funds are eligible for tuition expenses at private, public, and religious K-12 schools.
They can also be used to pay back student loans up to the lifetime limit of $10,000 per beneficiary of the plan.
What Are the Drawbacks to 529 Plans?
The main drawback to the plans is the inability to withdraw funds for “non-qualified” expenses. If you use the funds outside of the qualified education expenses, the distribution is subject to federal income taxes on the earnings and you may have to pay an additional 10% penalty on top of the earnings’ taxation. Some states like California also add an additional 2.5% penalty on top of the federal 10% penalty.
If you want more flexibility, consider diversifying the savings strategy to cover non-qualified expenses with investments in a taxable brokerage account or even a high yield savings account for your child depending on their age.
New Changes to 529 Plans
With the second update of the Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act 2.0), leftover 529 funds can now be rolled into a Roth IRA account. There are many stipulations, like the 529 plan must be open at least 15 years before the rollover. The max rollover limit is $35,000 (not adjusted for inflation) and is subject to the max contribution per year (currently $7,000, requiring 5 separate rollovers over 5 years). This allows some ability to still use funds if a plan has excess funds to meet your education goal. You’re also able to change a beneficiary on a 529 plan if you overfunded a college savings goal for the initial intended student.
What Amount Do I Need to Be Saving?
This is going to be highly dependent on the goals you have for your kids and the schools they plan to go to. Remember, even a little bit of savings can go a long way with the power of compound interest. Feel free to reach out to us for a customized savings strategy.
Happy saving!
Ben Kirchner, AAMS© / Financial Advisor
After starting his career at two Fortune 100 companies, Ben joined MD Financial in May of 2018. Ben advises over a hundred doctor households, helping them achieve their financial goals. He is passionate about serving. Ben enjoys making sure all of our doctors thrive financially and have a great experience every step of the way. He can be reached at Ben@mdfinancialadvisors.com.