In an article last month about saving for college, we outlined some of the many ways to handle overfunded 529 college savings plans and why these underpublicized options justify aggressive funding of 529 plans. In the opening paragraphs of that May article, we explained how the rules treat 529 account funds used for non-qualified expenses:
The first thing to understand about overfunded 529 plan accounts is that distributions for non-qualified withdrawals (i.e. using 529 funds to purchase a car, a big-screen TV, a family vacation, etc.) face two “penalties”:
1) A 10% penalty on the earnings portion of non-qualified withdrawals; and
2) Income tax on the earnings portion of non-qualified withdrawals.
Importantly, both of these penalties are incurred only on the earnings portion of a 529 plan balance – the value of the account above the amount of contributions.
We used last month’s article to explain several ways to effectively deal with extra 529 plan contributions. Parents and grandparents who seek to aggressively fund 529 plan accounts should not only understand the favorable options to get funds out without tax or penalty but they should also understand how a late-2015 rule change impacts the treatment of excess 529 funds, in order to use the rule change to their advantage.
What the End of 529 Plan Account Aggregation Means
The 2015 Bipartisan Budget Act garnered plenty of headlines for major changes to Social Security claiming strategies. Drowned in that fanfare were other important legal changes with useful financial planning implications, including the elimination of the Section 529 college savings plan aggregation rule. This change to the law simply meant that separate 529 accounts with the same beneficiary would no longer be aggregated for tax purposes but instead treated as separate entities. An example should help explain what this means and why it matters.
Consider the situation where parents funded two 529 accounts for their son, Theo – one in New York when they lived there right after Theo was born and the other in Georgia after moving south when Theo was in high school[i]. The New York 529 account, with a long time to grow, appreciated from an original investment of $30,000 to $100,000. Alternatively, the Georgia 529 account appreciated from $20,000 to $21,000 with only a short investment period.
Theo has now made a college choice and faces an estimated total of $100,000 in qualified college expenses. Under the old rules, it would not matter from which 529 account Theo’s parents distributed the funds to pay for his college since all accounts were aggregated for tax purposes. That is, the accounts are all treated as one big account with taxes and penalties on non-qualified distributions assessed accordingly. However, under the new law, Theo’s parents would be well-advised to distribute from the New York plan which has far greater appreciation. If they distribute the entire New York account and then take a non-qualified distribution of $21,000 from the Georgia account (assuming none of these other uses for 529 assets are applicable), they face a tax and 10% penalty only on $1,000 of earnings (from the lesser appreciated Georgia account). Had they instead fully depleted the Georgia account first and then been left with $21,000 on the New York account after covering the $100,000 of total qualified expenses, the same $21,000 non-qualified distribution would have resulted in tax and 10% penalty on $14,700 of earnings (because of the higher appreciation on the New York account).
Specifically, when the 10% penalty or the tax on gains from non-qualified distributions is calculated, it is only calculated on the gains in the specific account from where the non-qualified distribution came.
Practical Planning Implications of the 529 Plan Rule Change
Consider the practical implications that extend from the example above:
1) Parents with multiple 529 college savings plan accounts for the same child ought to use the account with the highest appreciation (in percentage terms) first to pay for qualified education expenses. This approach stems directly from the example above.
2) Parents with separate 529 plan accounts for multiple children should not always take the simplistic course of using child 1’s account to pay for child 1 and child 2’s account to pay for child 2. Modify the prior example so that Theo now has two younger siblings, Rudy and Vanessa, and that the parents created a 529 plan account for each child. Theo is headed off to college but his 529 account has barely any appreciation as it was funded in early 2008, right before the ‘great recession’. Alternatively, the account for Vanessa was funded in early 2009 near the market bottom and it has more than doubled.
The financially smart approach for the parents to take would be to transfer Vanessa’s 529 account into a new 529 account for Theo[ii] and then use this more highly appreciated 529 account to pay for Theo’s college expenses. The parents will again want to employ the same tactic when Vanessa goes to college, perhaps by using Rudy’s 529 assets to pay for Vanessa’s expenses. There is nothing overly complex about this approach. The key idea is to use the most highly appreciated accounts first to pay for qualified expenses so that if there are excess funds in 529 accounts after education expenses are paid for all three children, the tax and penalty on any non-qualified distributions (due from overfunding) will be dramatically reduced or eliminated.
3) The optimal plan for families who plan to aggressively save for college is to create multiple 529 accounts for each child and place different investments in each. Revert back to the previous example where Theo is an only child and his parents are using a 529 plan to save for Theo’s college expenses. If the target allocation for Theo’s college savings is determined to be 80% in stocks and 20% in bonds, the family would be well-advised to open two 529 accounts in Theo’s name – using one account for stocks (“the stock account”) and one for bonds (“the bond account”)[iii].
Fast-forward 15 years as Theo is headed off to college and it is likely that the stock account performance far outpaced that of the bond account. The family’s recommended strategy is then to distribute first from the stock account until it is completely depleted. Leaving the bond account until last means that if Theo ends up earning scholarships that reduce the college cost or college expenses are less than anticipated and there is resultantly money still left in the 529 accounts, the penalty and tax liability on the distribution of excess funds will be far less onerous than if all the investments were held together in one account.
Most families will find that qualified education expenses far exceed what they have saved in a 529 college savings plan. These scenarios would seem to make the planning strategies described above of no value. Yet applying such logic to term life insurance would suggest that the life insurance was a waste of time and money if the insured outlived the term. This is clearly not the case. The reality is that kids can get unexpected scholarships, go to an in-state college rather than private, graduate faster than anticipated, or the 529 assets can appreciate at a higher rate than expected.
Since there is generally no cost to using multiple 529 plan accounts[iv], the only real push-back to these planning strategies is the burden of creating and maintaining more than one account. However, two of the strategies suggested above are merely a way to deal with accounts that have already been set up. The third strategy simply suggests that families open an extra account and we find that most families already have more than one 529 account – usually because they created separate accounts for each child or grandchild.
At the end of the day, these are relatively painless tools to smarter financial planning. Taking the time to properly plan for overfunded 529 plan accounts could provide tax savings and penalty avoidance of thousands or tens of thousands of dollars.
[i] There was no reason that the parents needed to fund their home state 529 Plans other than the state income tax break that both Georgia and New York provided. They could have continued funding the New York plan after moving to Georgia but would have no longer captured the state income tax deduction.
[ii] Note that 529 account assets would need to be rolled over to Theo’s name in order to use them for Theo’s education expenses but this is a non-taxable, penalty-free event.
[iii]Over time, the family may rebalance to a more conservative allocation which would mean selling stocks in the stock account and buying bonds with proceeds.
[iv]Most states, including Georgia, do not charge an account fee for each additional account so there are generally no additional costs to using multiple 529 accounts.