Written by Greg Palacorolla, CFP®
One of, if not the largest expense that parents face, is putting their children through college. Between the cost of tuition, room and board, books, and meal money, college education has become a financial burden that many parents cannot overcome. However, despite the absurdity of the price, it’s an expense that is essential for the long-term success of your children; as a result, it becomes a priority for most.
There are a variety of savings accounts geared towards college planning. However, the best type of account from a tax, and subsequent growth perspective, is the Section 529 Plan. If you are a Maryland resident, tax advantageous features for both the child and the account holder are present, making it a no-brainer as the premier instrument to achieving your college planning goals.
Understanding the Tax Benefits
The primary tax benefit of all 529 plans, regardless of the sponsoring state, is the tax-free growth of the underlying investments. As long as the earnings on the contributions are used to pay for college education expenses, such as tuition, room/board, books, and calculators, the funds withdrawn are tax-free. The tax-free withdrawal feature of 529’s is identical to the increasingly popular Roth IRA retirement account. However, Roth IRA contributions are capped at $5,500 per year, which limits the long-term compounding factor of tax-free growth. Conversely, contributions to the MD 529 plan are unlimited up to an account balance of $350,000. You should be cognizant of the annual gift tax exclusion limit of $14,000 per year per account holder ($28,000 for parents), but the unrestricted nature of the contributions can be very beneficial. Also, you have the ability to utilize the “five year forward” rule, allowing each parent to contribute five years’ worth of contributions in the current year. Each parent can contribute $70,000 ($14,000/year x 5 years); thus, the total available investment in one calendar year into a 529 plan for a child is $140,000. $140,000 earning a modest 5% for 18 years would grow to $336,927, all of which is completely sheltered from tax. Most parents cannot afford to contribute $140,000 to a 529 account the day their child is born.
To illustrate a more realistic example, let’s assume that parents open an account for $10,000 when their child is born, make annual contributions of $5,000, and earn 5% on their money each year. In 18 years when the child is ready to attend college, the 529 account would be worth $171,761. Typically, the growth of these funds over 18 years would be subject to income and capital gains tax (Example 1: $196,927 would be taxable. Example 2: $71,761 would be taxable). However, as long as the withdrawn funds are used for qualified college expenses, you withdraw every dollar TAX-FREE. The combination of unrestricted contribution amounts and tax-free growth can be extremely beneficial when attempting to overcome this monumental expense.
The second significant tax benefit associated with the Maryland College Investment Plan (529) is the tax-deductibility of the contributions. Up to $2,500 of annual contributions per account holder, per child can be deducted on your Maryland state income tax return. Married couples can deduct a total of $5,000 ($2,500 each) per year for contributions made towards funding their children’s college education. Each parent would open a 529 account for their child. Annually, up to $5,000 can be deducted on their married filing jointly tax return. Between state and local taxes, the rate is typically around 7-8%. Apply that rate to your $5,000 contribution and you will lower your MD tax liability by $350-$400 per year. Quite the savings just for shifting money from a savings account into a 529 account (that subsequently grows tax-free!). Theoretically, if you have four children, parents could open eight 529’s, contribute $2,500 into each ($20,000), and then deduct the FULL amount on their MD income tax return. This could save them $1,600 (8% bracket) each year in income taxes.
Additional Beneficial Features of 529 Accounts
While the lure of 529 accounts centers around the significant tax benefits, there are several other features that further enhance the attractiveness of this specific savings vehicle.
Variety of Investment & Portfolio Options
The investment platform available for the Maryland 529 plan is solid. Investors have the ability to utilize fixed portfolios, ranging from conservative to aggressive, that are comprised of high quality, actively managed mutual funds. In addition, there are several enrollment based portfolios that simplify the investment allocation process for those who lack the time or knowledge to manage the account properly.
Ability to Transfer Unused Funds to Other Beneficiaries
A common concern that parents have is what happens if their child does not need the funds that were set aside. Maybe they received a full scholarship, elected an inexpensive college, or chose to bypass college altogether. All 529 plans allow the account owner to change the beneficiary to another family member without penalty and while preserving the tax benefits previously described. Therefore, if your eldest child does not have a need for some or all of his/her 529 account, the money you have set aside can be rolled directly to your next child who may plan to attend an Ivy League school. This flexibility adds to the appeal of 529’s.
Assets Removed from Estate
For ultra-wealthy individuals that potentially have an estate tax issue, funding 529 accounts is often used in strategic estate planning. Contributing thousands of dollars to children and grandchildren will lower the asset base that is subject to estate tax at death. The intriguing caveat from an estate planning perspective is that the account owner stills maintains control over the asset; however, it’s not included in their taxable estate. No other investment vehicle provides both benefits to an investor. An aging individual with assets over the estate tax exemption can fund 529’s for as many people as he/she wishes, up to an account balance of $350,000 (MD 529 funding limit). For example, if he/she has six grandchildren, funding six 529 plans will allow $2,100,000 to be removed from their estate immediately.
How Geier Asset Management Assists in the College Planning Process
College planning is a significant component of the financial planning process. While the 529 plan is our preferred savings mechanism, there are many other things to consider when planning for college. How much should I contribute monthly to reach my goal? How should I allocate the funds? Should I make adjustments regularly, and if so, how will I know what to do? These are some of the questions that we address in our college planning analysis. Projections are run based on factors such as current cost of college, inflation rates on tuition, and estimated rates of return. From there, we devise a plan that will identify the amount required and the estimated return needed to achieve your college funding goals. We’ll actively manage the 529 accounts for our clients, making regular adjustments based on current market conditions and the time horizon until the funds are needed. College planning is crucial for the long-term success of your loved ones. We are happy to handle the strategic planning and investment management, while utilizing the best college savings account available: the 529 plan.
© Geier Asset Management, Inc. June 2015. Greg Palacorolla is the Director of Wealth Management for Geier Asset Management, Inc., a Registered Investment Advisor. The above blog reflects the opinions of Mr. Palacorolla and not necessarily the firm. Any advice given is general in nature and investors must consider their own individual circumstances. Past performance is no indicator of future performance. The firm makes no warranties or representations of any kind relating to the accuracy or timeliness of the information provided.