You’ve saved and invested money in a 529 plan for years to pay for your son or daughter’s college education and the college enrollment time frame is coming up in the next year. Now that you’re getting ready to enter the “529 withdrawal phase”, you’ll want to be sure to make the right decisions when taking distributions from your 529 account. Here are your top three considerations:
- Learn how to take distributions to help you with financial aid. First, become familiar with the Free Application for Federal Student Aid (FAFSA) form. The way that a 529 plan is reported for dependent students, and counted for financial aid, typically depends on the owner of the 529 plan. Typically, a 529 plan owned by a custodial parent is counted as an investment and it may reduce need-based aid by a maximum of 5.64% of the asset’s value. Depending on your income, your 529 plan may or may not impact your child’s financial aid package. Withdrawals from 529 plans owned by the custodial parent, when used for qualified higher education expenses, are not typically counted as parent or student income. Typically, parents as owners of 529 plans get the most favorable treatments, so ideally the custodial parent should own the 529 plan.
If non-custodial, non-married parents, living separately or relatives (such as grandparents) own the 529 plan, then the assets are generally not listed on the FAFSA form. However, once the funds are withdrawn, the funds are considered to be the student’s untaxed income on the FAFSA form. Untaxed income can reduce the student’s eligibility for need-based financial aid by as much as 50% of the distribution amount, a much harsher impact than the 5.64% reduction based on the net worth of the parent assets. There are a couple of choices to consider: A. Before taking distributions, transfer the ownership to the parent or child as they both receive more favorable treatment for the 529 plan. B. Withdraw to pay for the senior year’s expenses and the treatment of income is irrelevant for applying for aid.
After the FAFSA is completed online that links to IRS data, you may need to fill out the CSS profile that is required by some colleges. Some colleges use their own formula with 529 plans to determine aid. Consider contacting your child’s college to inquire how 529 plan assets and withdrawals are used to determine aid that comes directly from the college.
- Avoid Non-qualified Distributions. 529 plan withdrawals are tax-free to the extent your child incurs qualified education expenses (QHEE) during the year. If you withdraw more than the QHEE, the excess is a non-qualified distribution. You or your beneficiary will have to pay income taxes and a 10% federal penalty tax on the earnings portion of the non-qualified distribution.
QHEE includes tuition, fees, books, supplies, computers and related equipment. As of January 1, 2018, qualified expenses include up to $10,000 per year per beneficiary in tuition expenses at private, public or religious elementary, middle and high schools. You cannot include room and board costs in excess of the amount the school includes in its “cost of attendance” figures for federal financial aid purposes. If your child is living off campus, ask the financial aid department for the room and board allowance for students living at home with parents, or living elsewhere off campus. If your child is living in campus-owned dormitories, then use the amount the school charges for its room and board.
If you receive a distribution check from your 529 plan only to discover that you’ve taken too much, and you are still within the 60-day rollover window, you can take the excess and roll it to a different 529 plan so that this amount is no longer treated as a distribution, provided you have not rolled over that child’s 529 account within the prior 12 months. If you are outside of the 60-day window, but within the same calendar year, then consider prepaying for the next year’s expenses now. I suggest that you create a worksheet to track actual QHEE and file the receipts with it in case you get an audit from the IRS. You can take one distribution early in the year based on known tuition bills and then take another distribution in December after knowing the exact QHEE for this calendar year to avoid non-qualified distributions and avoid taking too little money from the 529 plan.
If you withdraw the 529 plan in December for a tuition bill that is not paid until next January, you may not have enough QHEE during the year of 529 withdrawal. Therefore, you must match the QHEE to the distributions in the same calendar year to avoid additional taxes and penalties.
- Review investment choices and make timely adjustments. Similar to preparing for your retirement, as you get closer to the time of taking withdrawals, your 529 plan investments must be reviewed and adjusted to match the withdrawal amounts and timeframe. Your 529 plan accounts probably have performed well in the past decade by investing mostly in stock funds due to a very long bull stock market. However, if you don’t make adjustments, you may have 80% to 90% in equity funds that could potentially lose 30% during a severe stock market decline in the next year or two and this portfolio wouldn’t have enough time to recover the losses, as your child does not delay going to college.
Some 529 plans offer an aged-based investment option that seeks to match your investment objective and level of risk to your investment horizon by factoring in the child’s current age and the number of years before they turn 18. As a beneficiary nears college age, the age bands invest less in mutual funds that invest in equity and real estate securities and more in mutual funds that invest in debt securities and in other investments that seek to preserve principal.
For example, for a 17 year old, the age band may have 18% in equity funds, 2% in real estate, 35% in fixed income funds and 45% in principal protected (stable value). Each person’s 529 plan balance and withdrawal amounts are different for four to seven years. Using the age-based investment option does not fit the person perfectly, but it’s probably better than picking a few funds on your own without a trusted advisor. Personally I prefer to use the 529 plans that offer both age-based investment options and various low cost customized investment options including global equity funds, short-term corporate notes, commercial paper, certificate of deposit and FDIC-insured. Some age-based investment options don’t include stable value and FDIC-insured choices which can become very important when you know you must withdraw over 50% of the balance over the next two years as intermediate term and long-term fixed income could lose value due to interest rate hikes, and stock markets could decline sharply. Having various customized investment options that protect the principal is more critical when the beneficiary is less than two years from college.
For someone who has too much in the 529 plan, the balance after graduation can potentially be used for graduate school. It can be invested with more in equity, based on the estimated new time horizon. If your child does not go to graduate school, he can use it to take classes for fun from universities in the future. If you have another child, you can change the account beneficiary to another child or the beneficiary’s cousin. You can also take college classes for fun yourself by changing the account beneficiary to yourself and use it without paying taxes and penalties. Because you can change beneficiaries as many times as you want, any excess funds in your 529 plan can remain there to be passed down from generation to generation (check to see if your 529 plan has a restriction on how long the account can stay open – many do not).
For Minnesotans, starting on January 1, 2017, you can deduct up to a $3,000 contribution to any 529 plan (not limited to the Minnesota 529 plan) per year on Minnesota income tax return. The maximum deduction is $3,000 per family and it does not matter if you contribute $3,000 to one child's 529 or allocate it among a few children's.
Invest in your children’s college education by planning ahead so that they won’t be burdened by a large student loan. Engage them early in this saving and investing process so that they understand the value of money and learn disciplined saving and investment strategies.
This month, I received a heart-warming email message from a long-term client who recently retired. “One of the very best things we ever did (and it made early retirement much easier) was to fully fund our children’s public university (U of MN) education and then engage them in that budgeting process. It has been truly a miracle.”