It’s no secret that college can be expensive. Currently, the average cost for one year of an in-state university is around $25,000 and for a private college it’s closer to $50,000 with many Ivy League schools topping $65,000.  When we do education planning for our clients the numbers are even more daunting.  Over the past decade college costs have inflated at an average rate of 5%. If that current trend continues a child who is 10 years old today is looking at a cost of $37,000 for their freshman year at a hypothetical in-state university. For private school the first year will average $74,000.

This is a huge expense for most families. Although some students will be offered financial incentives based on academics or sports, not everyone will receive scholarships or grants. Even for those who receive some financial aid it is rare that a student receives a full ride, so it’s wise to plan on covering a substantial amount of the cost of the college.  There is a myriad of ways to meet these financial needs including work-study programs, reducing costs, taking on student loans and planned savings. Generally, it is some combination of these strategies that families ultimately use.

One of our favorite methods for saving for college is through a Section 529 plan, also known as a qualified tuition program. These plans are a tax-advantaged way to help pay for education; the tax advantage can be even greater for South Carolina residents who utilize the unlimited state tax deduction.

How Does a 529 Plan Work?

529 plans come in two different varieties. The first is Prepaid Tuition Plans which allow you to purchase “units” of tuition at today’s price. This allows you to insulate college expenses from future inflation. Typically, these do not cover room and board (they are tuition only) and school choice is limited. The second and more common type of 529 is an Education Savings Plan. In terms of tax treatment, 529 plans function much like a Roth IRA.

529 savings plans are unique to each state so there are many options from which to choose and the choices can be overwhelming. Step #1 is to evaluate the plans available in your home state to see if there are any tax benefits and assess the quality and cost of the investments provided.  Once selected, step#2 is to open an account, generally in the name of the parents or grandparents for the benefit of the child.  Step #3 is to fund the account and select the underlying investments. There are generally a range of investment options that can be chosen based on time horizon (age of the child) and risk tolerance. The money that is deposited is after-tax (like a Roth IRA), but it grows tax deferred and if used to qualified education expenses, is not taxed upon withdrawal.

How Much Can You Contribute to a 529 in 2019?

While the tax attributes of a 529 plan are like a Roth IRA, 529s allow for much more hefty annual contributions. The limit is equal to the annual gift tax exclusion amount. For 2019 that amount is $15,000 per student per year. If a married couple agrees to gift splitting this amount doubles to $30,000 per student per year. Gifts above this amount require filing form 709 with the IRS. Gift tax would only be due if the donor had already used their entire lifetime unified credit amount, which is currently $11,180,000.

There is a special gift tax rule that allows a taxpayer to gift (or frontload) 5 years’ worth of excluded gifts up front per beneficiary. This means that for 2019 $75,000 could be gifted into a 529 plan beneficiary by a single donor without exceeding the annual gift exemption amount. A married couple may gift split for a total of $150,000. This can only be done once every 5 years and any other gifts made during that time (for that beneficiary) will exceed the annual gift exclusion and form 709 will need to be filed for that year. This strategy can be particularly attractive for wealthy grandparents who may want to remove the assets from their estate.

Who Can Contribute to a 529 Plan?

Anyone can contribute to a 529 plan for any beneficiary. There does not have to be a familial relationship between the donor and the future student. A beneficiary can also have more than one 529 plan. It is very common for grandparents to open 529 plans for their grandchildren while parents fund a separate 529 plan. This is especially useful for families that live in different states and their respective home states offer income tax incentives. Let’s say you live in South Carolina, but your son and two grandchildren live in Ohio. Your son has established an Ohio 529 plan for each of your grandchildren. You could contribute to the plans that are already established in Ohio, but you would not be able to deduct the contribution from your South Carolina state income tax. The second option would be to open new 529 plans for each of the grandchildren in South Carolina. This would allow you to deduct all your contributions from your state income tax in the year you make contributions.

Investment Options in the South Carolina 529 Plan

Te South Carolina Future Scholar (www.futurescholar.com)  plan offers a good array of investment options from Columbia Threadneedle and Vanguard. The funds offer broad equity and fixed income exposure at a low cost. The plan also offers age-based portfolios that automatically become more conservative the closer the student gets to matriculation. With three different risk levels (conservative, moderate and aggressive), the age-based portfolios can work well in a wide variety of scenarios and they have the benefit of automating the risk adjustment process as the student ages.

Unlimited South Carolina State Tax Deduction 

Residents of South Carolina who are contributing to South Carolina’s 529 plan, Future Scholar, can also enjoy an unlimited deduction on SC state income tax. There is also no income phase-out or limits for this deduction making it a great option for high income parents or grandparents who file income tax in the Palmetto State. You have until the tax deadline (April 15th, 2020 for 2019 income taxes) to contribute to a 529 and still make the state income tax deduction for the 2019 tax year.

Some families use a strategy wherein they contribute to a 529 for tuition that will be paid during the year and withdraw it shortly thereafter when the bill comes due; even though very little time has passed, they still receive the tax deduction. There is no minimum amount of time the funds need to stay in the account in order to receive the tax deduction. This is a great tax planning tool for those that pay tuition bills out of cash flow or from other savings sources.

What Expenses Can You Use 529 Plan Funds For?

Money in a 529 plan can be used to pay “qualified education expenses” tax and penalty free. Qualified expenses include tuition and fees for college, vocational or trade schools, grad school, medical school and any other post-secondary education. Room and board can be paid for with 529 funds and this can include off campus housing so long as the amount does not exceed what the student would have paid on campus. Books, computers and supplies needed for classes can also qualify.

The passing of the Tax Cuts and Jobs Act also liberalized the rules on how 529 plan funds can be used, extending them for the first time to private K-12 school tuition. Starting in 2018 $10,000 per year maybe used from a 529 to pay for elementary, middle and high school tuition at private schools. The South Carolina state income tax deduction alone can be a big help for families with children and grandchildren in private school. There may not be enough time to enjoy tax free investment returns in these situations, but at least you will see savings on state income taxes.

What is excluded? Expenses not considered “qualified” for tax and penalty-free withdrawal include sports equipment, insurance payments, transportation expenses, room and board costs above what the school charges, and repayment of student loans. If funds from a 529 plan are used for these non-qualified expenses, there is a 10% penalty and tax on any investment earnings. It is important to keep detailed records of what 529 plan funds were used for. If in doubt, consult with your CERTIFIED FINANCIAL PLANNER™ or CPA for guidance.

Keep in mind that you cannot double up on tax savings. Special care must be taken when using education tax credits like the American Opportunity or Lifetime Learning credits. If claiming either of these credits one must deduct the amounts of the tax credit from the qualified education expenses.  529 Plan distributions that exceed this adjusted amount are taxable.   Furthermore, you can’t use both credits for the same student in the same year.

What Happens if Money in a 529 Plan is Not Used?

Some parents are concerned about the possibility of over-contributing to a 529 plan.  What happens if the child doesn’t go to college or receives financial aid and does not use all the funds in the account? The owner of the 529 account (typically the parent) can change the beneficiary on the account without penalties.  However, the new beneficiary must be a family member- such as another sibling, niece or nephew or even the parents themselves. If you are the parent of a child who is not going to use all or any of their 529, you can always leave it in their name and, once they have a child, change the beneficiary to your new grandchild. They money in the account will have an additional 18+ years to grow tax deferred in this case.

As previously mentioned, withdrawing cash for a non-qualified expense results in a 10% penalty and tax on the investment gains. Although not ideal, it is an option. No penalties will be due until the money is withdrawn, so it can be left in the account and only withdrawn if needed for emergencies.

Should You Open a 529? 

We really like 529 plans for education funding but there are a lot of different factors to consider, including which plan to use, which investments to choose, how much to contribute. The amount is especially important as there are risks to both over-funding and under-funding the account. We recommend speaking to a CERTIFIED FINANCIAL PLANNER™ before making an education savings decision. This will allow you to develop an education savings plan that looks at your entire financial situation.