Can you escape this 529 tax consequence?

The Section 529 Plan is one of the best vehicles for accumulating education funds, because they can benefit both the student and the contributor. The funds grow without any tax consequences, and when used for education expenses[ Qualified education expenses include tuition, room & board, books, many fees and computers. ] the earnings are tax free. The contributor gets to apply the gifts toward their gift tax exclusion and can “front load” up to five years of annual gifts. Finally, and perhaps most important, the contributor can change the beneficiary if college funding is not needed.

Sounds like a slam-dunk, doesn’t it?

Not so fast.

Most often it’s the grandparents that create plans for their grand kids. Let’s be honest, mom and dad are most likely starting their careers and struggling to provide all the daily necessities. But grandpa and grannie want to pass something along to their newest pride and joy. So, on advice of their financial advisor, they set up Section 529 College Savings plans for each of the grand kids. Some make sizeable one-time contributions, up to the initial limit of $75,000, while others make a minimal monthly contribution, as little as $25.

Still sounds like a pretty good plan, doesn’t it?

But what happens when the grandkid is ready to go to college?

Sometime around their junior year in high school, it’s a great idea to start talking with the financial advisor about the withdrawal strategy, because if it’s not done right, there could be unexpected consequences. Coincidentally, that’s also about the time most kids start their college search, so it’s a good idea to include financial planning into the college search discussion.

What’s the big deal? You said the funds get withdrawn tax-free if used for college.

Ah, that’s true, but if the plan is still owned by anyone other than the parents, the withdrawals are considered income to the beneficiary on the infamous FAFSA form. Sort of. The FAFSA looks for 529 payments only from two years prior, so it makes sense if there isn’t enough money in the plan to pay for more than two years of qualified expenses, to use them for the final two years of college, not the first two.

In other words, when completing the FAFSA prior to year three of college, the form asks about 529 funds used to pay for the freshman year[ Assuming a four-year education plan.]. If none were used, there’s no impact on the FAFSA-related financial aid award. But if they were used, there are different calculations based on who is listed as the owner of the plan. If grandma and grandpa own the plan, the full impact is counted as the student’s income. But if a parent owns the plan, only a small percentage of the funds are counted as income, reducing the expected family contribution, thereby increasing the possible financial aid award.

Circling back to the high school junior year, if the plan is to use the funds during the first two years of a four-year college plan, and financial aid is expected, it’s a good idea to transfer control of the 529 plan to the parents.

As with all financial milestones, please reach out to an Enduring Wealth Advisor® for guidance as you approach the expenses of education funding.

Prior to investing in a 529 Plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing. Non-Qualified withdrawals may result in federal income tax and a 10% federal tax penalty on earnings.

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