Cashing in With Tax Reform
Tax law changes make early saving for education expenses all the more enticing.
By MARK GILBERT, CPA, PFS |
Among the many savings and investment vehicles students
and parents can use to finance education expenses — think
Coverdell Education Savings Accounts, Roth IRAs, and U.S. savings
bonds — the most popular plans just got a shot in the arm thanks
to tax reform.
Around since 1996, 529 plans, or “qualified tuition plans,” are tax-advantaged
savings plans sponsored by states, state agencies, or
educational institutions, and authorized by Section 529 of the
Internal Revenue Code, to encourage education saving.
The Tax Cuts and Jobs Act of 2017 introduced some important
changes to 529 plans that should only further their popularity. Here
are the highlights — and some practical ideas for implementation
529 plans come in two types: (1) prepaid college tuition savings
plans, and (2) defined contribution-type account balance
plans, which are funded with “after-tax” contributions. 529 plan
contributions grow on a tax-free basis, much like in a Roth
IRA, and withdrawals remain tax-free if used for qualified
Previously, “qualified education expenses” meant only certain
college-related expenses. Now, the law permits up to $10,000 per
year of tax-free withdrawals from 529 account balance plans to
cover tuition and fees of public and private elementary and
This is a dramatic expansion, which allows 529 account balance
plans to essentially replicate or replace Coverdell Education
Savings Accounts (ESAs). While annual contributions to
Coverdell ESAs are limited to $2,000 per child, annual 529 plan
contributions max out at the gift exclusion amount of $15,000
per donor per child, or $75,000 if “front loading” five years’
worth of contributions, a prudent estate planning strategy often
used by grandparents.
It’s my hope that the expanded use of 529 account balance plans
will encourage families to start saving earlier in a child’s life. With
education costs continuing to rise, the more time allowed for
contributions to grow prior to withdrawal, the better.
I generally recommend funding 529 plans for college to cover
about 66 percent of the anticipated total expense, with the
remaining 33 percent coming from other savings, investments, current cash flow, and scholarships or financial aid. For families
wishing to send children to private elementary or secondary
schools, I believe funding a 529 plan account to cover 100 percent
of the qualified costs is best because the availability of scholarships
and financial aid is more limited. Additionally, any unused 529
plan funds can be used for college or another child’s education.
How should 529 plan funds be invested? As you would with your
retirement savings, you must consider risk tolerance and time until
funds will be withdrawn to form a reasonable investment strategy.
While each family’s situation is unique, I often recommend an age-based
methodology: the youngest child’s account is invested
heavily in equities while the oldest child’s account is invested more
in bonds and cash. When investing for elementary and secondary
school, the same philosophy holds — the shorter time frame until
need means these accounts should be in fewer equities and more
in stable income vehicles. I also recommend setting up separate
accounts for each child’s college, elementary, or secondary
education expenses to better manage the funding goals.
COVERDELL ESAs ELIMINATED
Thanks to the new tax law’s 529 plan expansion, Coverdell ESAs
are essentially obsolete. In fact, lawmakers have ruled 529 plans
to be the superior education savings vehicle and have eliminated
the option of new Coverdell ESAs. Why would they do this? First,
as noted earlier, 529 plans benefit from having higher contribution
limits. Second, there’s no age limit on disbursing 529 plan funds,
whereas Coverdell ESA funds must be disbursed by the time the
child or beneficiary reaches age 30. The only downside of this
move is that 529 plans generally have limited investment options
whereas Coverdell ESA funds could have been invested in nearly
any publicly traded security.
So, what now? I recommend existing Coverdell ESAs be rolled over
to 529 plans to obtain the more generous benefits.
ABLE, aka Achieving a Better Life Experience, accounts were created
by 2014 legislation designed to assist individuals with disabilities.
These accounts are similar to 529 plan accounts in that they can
receive a maximum after-tax contribution of $15,000 per year and
grow on a tax-deferred basis that becomes tax-free if used for
“qualified disability expenses.” These qualified expenses include
education, housing, transportation, health care, and financial
management to improve the quality of the disabled beneficiary’s life.
The primary benefit of the ABLE account is that a wide range of
expenditures can be made, and assets accumulated, without
disqualifying the disabled beneficiary from various public service
benefits like Social Security, Medicaid, and SNAP (“food stamps”).
Thanks to tax reform legislation, 529 plan accounts can now be
rolled over to ABLE accounts. This is a great benefit for families
who have funded 529 plan accounts for children who later became
disabled and are unable to attend college.
The new tax law has set forth several changes that surely will
increase the popularity and usability of 529 plans. Whether for your
family’s own benefit, or for your clients’, I encourage you to further
familiarize yourself with the nuts and bolts of these savings plans
that can drastically improve future finances.