By: Rachel Roth, Wealth Management Advisor Associate
Does it Still Make Sense to Invest?
The college experience was redefined in the Spring of 2020 as classes went online and dormitories closed due to Coronavirus concerns. Many colleges and universities issued a partial refund of tuition and room and board. If you used your child’s 529 plan to pay these expenses in the Spring of 2020 and your student was issued a refund, the IRS says it needs to be put back into your 529 account or the account owner could face tax penalties at the end of the year. Since the refund is not being used for qualified expenses, it could be recharacterized as taxable income to the account owner (usually a parent). This could mean a 10% penalty and income taxes on the earnings portion of the returned distribution amount.
To avoid this tax pitfall, there are several actions you can take:
First, you can deposit the funds back into your 529 plan by writing a check and sending a letter outlining the details of the refund, requesting that it be classified as a recharacterization of a previous qualified withdrawal. This must be done within 60 days from the issue date of the refund. Be sure and keep copies of all documentation for your records.
The second action you can take is to hold the refund and reapply to the upcoming semester. You can offset your Fall semester withdrawal from the 529 plan by reducing the total amount needed for the Fall Semester by the Spring semester’s refunded amount. Remember to use your 529 plan for qualified withdrawals within the same tax year they were incurred.
Does it still make sense to contribute to a 529 during a pandemic and beyond? Yes. Higher education may be adapting to new norms, but there will still be substantial costs and 529 plans are a great resource for meeting your college savings objectives.
When it comes to saving for college, a 529 plan has very few restrictions for opening an account. Any US citizen or resident alien 18 years or older with a social security number is eligible to open a 529 account, regardless of income level. The account owner will always remain in control of the account. The maximum you can contribute per year is dependent on the federal gift tax limits (which we will cover below).
Plan changes over the last few years have made 529’s more flexible in a world filled with uncertainty. In addition to 2-year, 4-year, and graduate degrees, you can now use your 529 funds to cover registered apprenticeships in skilled trades, K-12 tuition, and repay qualified education loans.
529s still provide solid tax and financial aid benefits. Contributions are made using after-tax dollars, but the earnings that are accumulated grow on a tax-deferred basis. Qualified distributions from the plan are tax-free.
35 states1 offer a state income tax deduction or credit when contributions are made to the account owner’s home state 529 plan. Of course, Texas doesn’t have a state income tax, so Texans do not get the benefit of a state tax deduction or credit.
There is an exception to the annual $15,000 ($30,000 per couple) federal gift limit where you can front load the plan by making a lump sum payment of $75,000 ($150,000 per couple). It is treated as contributions occurring proportionately over a 5-year period, which eliminates the gift tax. Furthermore, once assets are in the account, they are generally considered to be out of the account owner’s estate, potentially saving on estate taxes.
Like most investors, parents are concerned with market performance over the life of the college savings account and coming up short when it’s time to pay the bills. While we cannot predict future market conditions, both younger and near college-age beneficiaries affected by the pandemic’s economic impact could hypothetically make up those losses in less than a year.
For example, according to the data from Morningstar2 those with a shorter time horizon who are in college will need a return of 2.36% on average as of March 31, 2020 to recoup their loss from the market’s Coronavirus downturn. The good news is that for the same time horizon for college savings 529 portfolios, the average market return for the last 9 years has been 2.82%, which is greater than what is needed to recoup the recent losses.
In addition to market performance, there are levers you can pull to help maximize your gains and create the desired outcome from your portfolio. Choose a plan that has low program fees and mutual fund expenses. Many plans have an age-based asset allocation model that is more aggressive when the child is young and shifts to more conservative allocation when the child nears 18. This approach takes a “set it and forget it” approach allowing the saver to potentially protect more of the principal over the long-term.
We are always here to help you with these topics and any other financial questions that you and your family may have. Please contact us with any questions.
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