Alfred E. Neumans Guide to 529 Plans

Financial Professional Content You may meet resistance when recommending 529 plans to your clients stemming from certain fears and misconceptions about how these college savings programs work. Alfred E. Neuman, the iconic face of Mad Magazine and the phrase "What? Me worry?" would offer up the following responses to the concerns of parents and grandparents (if he was asked). "I'm worried about the high costs in a 529 plan." Neuman: Dude, have you looked at the expenses in your 401(k) plan? That's where you should be complaining. [Editor's note: if you are a financial advisor handling 401(k) assets, you might be reluctant to make this point.] Regardless, expenses in 529 plans have been driven down to the point where they are no longer a good reason for staying away. You can thank the states for putting the fee pressure on their investment managers. High-quality and low expenses in a tax-free investment vehicleï ¿ ½what more could you want? "But I'm worried that I might not be able to change investments in my 529 account if the stock market goes south." (Photo Credit: Flickr) "But I'm worried that I might not be able to change investments in my 529 account if the stock market goes south." Neuman: Hey, I've got some great news for you. Starting in 2015, you can change investments in your 529 account twice each year. I admit, this is still fairly restrictive, but it sure is a lot better than the old limit of one change per year. Remember, too, that an investment change accompanied by a beneficiary change does not count against your allowance of two changes per year. Beneficiary changes are simple to do, especially if you have at least two children, with no limit on how often you can change beneficiary. Oh, you'd rather pick your own stocks and bonds in a college savings account? Maybe even do a little day-trading? Sorry, I can't give you a 529 plan that allows active self-management. But I'll be happy to join you at the craps table in Vegas. "I'm worried because my accountant says I can't claim the American Opportunity Tax Credit if I use a 529 plan." "I'm worried because my accountant says I can't claim the American Opportunity Tax Credit if I use a 529 plan." Neuman: Your accountant sounds like a bad-news bear. More likely, you didn't hear (or remember) the full story surrounding the "coordination" of tax incentives. This becomes an issue you face once your child gets to college and you begin taking withdrawals from a 529 plan. Nothing prevents you from claiming the American Opportunity Tax Creditï ¿ ½assuming you are eligible to claim the creditï ¿ ½and taking tax-free withdrawals from a 529 plan in the same tax year. You just can't use the same expenses for both tax incentives. The most logical solution for many taxpayers is to anticipate taking the credit, and simply subtract $4,000 from your student's qualified college costs when deciding how much to withdraw from your 529. But let's say you make the "mistake" of sending 529 funds directly from the 529 plan to the school for 100% of the college tuition and housing bills. You may end up with a $4,000 "non-qualified withdrawal." This really isn't such a bad thingï ¿ ½the $4,000 piece ends up being a tax-deferred investment rather than a tax-free investment. The 10-percent tax penalty is waived, and if the income on the 529 withdrawal is reported on the student's tax return where there may be little if any additional tax liability. "I'm worried that I will have to pay big penalties if I put a lot of money into a 529 plan and my child (or grandchild) gets a scholarship, or perhaps doesn't even go to college." "I'm worried that I will have to pay big penalties if I put a lot of money into a 529 plan and my child (or grandchild) gets a scholarship, or perhaps doesn't even go to college." Neuman: If you don't want to pay a tax or penalty on unneeded 529 funds, just keep the money in the plan. No one is forcing you to take a withdrawal, at any time or for any particular reason, as long as the account continues to have a beneficiary named on it. Look at meï ¿ ½do you think I ever went to college? No, I became rich and famous without the benefit of a degree. But my parents still have a 529 account for me. Maybe they think I'll eventually return to college. Maybe they think I will someday get married and have kids, and the money can be used to educate those grandchildren, or great-grandchildren, or great-great-grandchildren. It's certainly an easy, powerful, and flexible way to establish a tax-deferred, multi-generational educational legacy. If you do wish to take the leftover funds out of your 529 account, that is your right. In fact, you can withdraw at any time for any reason, although the earnings will be subject to tax and a possible 10-percent penalty. The penalty is waived to the extent the beneficiary received any tax-free scholarships throughout their college career. "I'm worried that saving in a 529 plan will ruin my child's chances for financial aid." "I'm worried that saving in a 529 plan will ruin my child's chances for financial aid." Neuman: So what are you going to doï ¿ ½spend yourself poor so you have no savings to report on the FAFSA? Remember this: family income is a much bigger factor than family assets in the financial-aid formula. And with your combined incomes, your child is not likely to qualify for need-based aid. If you have no savings, you're stuck. Can you say "student debt"? So maybe you're thinking a Roth IRA is the better way to save for college. After all, you can take back your contributions tax-free and penalty-free, and on top of that, retirement assets do not get reported on the FAFSA. But here's the rub: your tax-free IRA withdrawals in any year have to be added back as base-year income on the following year's FAFSA. And remember what I said about the impact of income? Many other savings alternatives will increase income on the FAFSA by generating taxable interest, muni interest, dividends, capital gains, etc. Distributions from grandparent-owned 529s also generate an income add-back, so Grandma and Grandpa might want to hold off on 529 distributions until junior/senior years, after the final FAFSA has been filed. "But I'm hearing from others that schools are now asking more questions and taking away scholarship money when they see money in 529 plans." "But I'm hearing from others that schools are now asking more questions and taking away scholarship money when they see money in 529 plans." Neuman: Yes, I suppose schools can do whatever they want with their own scholarship awards, including penalizing families with savings set aside in a 529 plan. (They don't have this flexibility when dispensing federal student aid, which must adhere to federal rules.) If you decide to save in a 529 plan, and your child is considering a school that awards its own need-based scholarships, you should ask about their policies concerning 529 plans BEFORE your child enrolls, just like you compare tuition charges when deciding on a college. So what do you do if your child is dead-set on attending a college where her large scholarship might get adjusted? Get back to me when that happensï ¿ ½I might have a few other suggestions for changing things to get the best treatment for your 529 account. "I'm worried that the federal government is going to change the rules surrounding 529 plans and take away my tax benefits." "I'm worried that the federal government is going to change the rules surrounding 529 plans and take away my tax benefits." Neuman: What, you don't trust the politicians to keep their word? LOL. Actually, I suppose they could change the rules at any time in the name of "tax reform." But if it's any comfort to you, the 15-year history of Code section 529 is full of amendments, and just about all of them made 529 plans even more attractive to college savers. It also doesn't hurt that most members of Congress, as well as President Obama, have 529 plans for their own children and grandchildren. I don't think you should worry so much. Originally posted 2014-12-23. Financial Professional Content You may meet resistance when recommending 529 plans to your clients stemming from certain fears and misconceptions about how these college savings programs work. Alfred E. Neuman, the iconic face of Mad Magazine and the phrase "What? Me worry?" would offer up the following responses to the concerns of parents and grandparents (if he was asked). "I'm worried about the high costs in a 529 plan." Neuman: Dude, have you looked at the expenses in your 401(k) plan? That's where you should be complaining. [Editor's note: if you are a financial advisor handling 401(k) assets, you might be reluctant to make this point.] Regardless, expenses in 529 plans have been driven down to the point where they are no longer a good reason for staying away. You can thank the states for putting the fee pressure on their investment managers. High-quality and low expenses in a tax-free investment vehicleï ¿ ½what more could you want? "But I'm worried that I might not be able to change investments in my 529 account if the stock market goes south." (Photo Credit: Flickr) "But I'm worried that I might not be able to change investments in my 529 account if the stock market goes south." Neuman: Hey, I've got some great news for you. Starting in 2015, you can change investments in your 529 account twice each year. I admit, this is still fairly restrictive, but it sure is a lot better than the old limit of one change per year. Remember, too, that an investment change accompanied by a beneficiary change does not count against your allowance of two changes per year. Beneficiary changes are simple to do, especially if you have at least two children, with no limit on how often you can change beneficiary. Oh, you'd rather pick your own stocks and bonds in a college savings account? Maybe even do a little day-trading? Sorry, I can't give you a 529 plan that allows active self-management. But I'll be happy to join you at the craps table in Vegas. "I'm worried because my accountant says I can't claim the American Opportunity Tax Credit if I use a 529 plan." "I'm worried because my accountant says I can't claim the American Opportunity Tax Credit if I use a 529 plan." Neuman: Your accountant sounds like a bad-news bear. More likely, you didn't hear (or remember) the full story surrounding the "coordination" of tax incentives. This becomes an issue you face once your child gets to college and you begin taking withdrawals from a 529 plan. Nothing prevents you from claiming the American Opportunity Tax Creditï ¿ ½assuming you are eligible to claim the creditï ¿ ½and taking tax-free withdrawals from a 529 plan in the same tax year. You just can't use the same expenses for both tax incentives. The most logical solution for many taxpayers is to anticipate taking the credit, and simply subtract $4,000 from your student's qualified college costs when deciding how much to withdraw from your 529. But let's say you make the "mistake" of sending 529 funds directly from the 529 plan to the school for 100% of the college tuition and housing bills. You may end up with a $4,000 "non-qualified withdrawal." This really isn't such a bad thingï ¿ ½the $4,000 piece ends up being a tax-deferred investment rather than a tax-free investment. The 10-percent tax penalty is waived, and if the income on the 529 withdrawal is reported on the student's tax return where there may be little if any additional tax liability. "I'm worried that I will have to pay big penalties if I put a lot of money into a 529 plan and my child (or grandchild) gets a scholarship, or perhaps doesn't even go to college." "I'm worried that I will have to pay big penalties if I put a lot of money into a 529 plan and my child (or grandchild) gets a scholarship, or perhaps doesn't even go to college." Neuman: If you don't want to pay a tax or penalty on unneeded 529 funds, just keep the money in the plan. No one is forcing you to take a withdrawal, at any time or for any particular reason, as long as the account continues to have a beneficiary named on it. Look at meï ¿ ½do you think I ever went to college? No, I became rich and famous without the benefit of a degree. But my parents still have a 529 account for me. Maybe they think I'll eventually return to college. Maybe they think I will someday get married and have kids, and the money can be used to educate those grandchildren, or great-grandchildren, or great-great-grandchildren. It's certainly an easy, powerful, and flexible way to establish a tax-deferred, multi-generational educational legacy. If you do wish to take the leftover funds out of your 529 account, that is your right. In fact, you can withdraw at any time for any reason, although the earnings will be subject to tax and a possible 10-percent penalty. The penalty is waived to the extent the beneficiary received any tax-free scholarships throughout their college career. "I'm worried that saving in a 529 plan will ruin my child's chances for financial aid." "I'm worried that saving in a 529 plan will ruin my child's chances for financial aid." Neuman: So what are you going to doï ¿ ½spend yourself poor so you have no savings to report on the FAFSA? Remember this: family income is a much bigger factor than family assets in the financial-aid formula. And with your combined incomes, your child is not likely to qualify for need-based aid. If you have no savings, you're stuck. Can you say "student debt"? So maybe you're thinking a Roth IRA is the better way to save for college. After all, you can take back your contributions tax-free and penalty-free, and on top of that, retirement assets do not get reported on the FAFSA. But here's the rub: your tax-free IRA withdrawals in any year have to be added back as base-year income on the following year's FAFSA. And remember what I said about the impact of income? Many other savings alternatives will increase income on the FAFSA by generating taxable interest, muni interest, dividends, capital gains, etc. Distributions from grandparent-owned 529s also generate an income add-back, so Grandma and Grandpa might want to hold off on 529 distributions until junior/senior years, after the final FAFSA has been filed. "But I'm hearing from others that schools are now asking more questions and taking away scholarship money when they see money in 529 plans." "But I'm hearing from others that schools are now asking more questions and taking away scholarship money when they see money in 529 plans." Neuman: Yes, I suppose schools can do whatever they want with their own scholarship awards, including penalizing families with savings set aside in a 529 plan. (They don't have this flexibility when dispensing federal student aid, which must adhere to federal rules.) If you decide to save in a 529 plan, and your child is considering a school that awards its own need-based scholarships, you should ask about their policies concerning 529 plans BEFORE your child enrolls, just like you compare tuition charges when deciding on a college. So what do you do if your child is dead-set on attending a college where her large scholarship might get adjusted? Get back to me when that happensï ¿ ½I might have a few other suggestions for changing things to get the best treatment for your 529 account. "I'm worried that the federal government is going to change the rules surrounding 529 plans and take away my tax benefits." "I'm worried that the federal government is going to change the rules surrounding 529 plans and take away my tax benefits." Neuman: What, you don't trust the politicians to keep their word? LOL. Actually, I suppose they could change the rules at any time in the name of "tax reform." But if it's any comfort to you, the 15-year history of Code section 529 is full of amendments, and just about all of them made 529 plans even more attractive to college savers. It also doesn't hurt that most members of Congress, as well as President Obama, have 529 plans for their own children and grandchildren. I don't think you should worry so much. Originally posted 2014-12-23.