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IRS Code Sec 529 Plans Can Shrink Your Education Savings

This article is slated to be updated with the latest FAFSA, Scholarship, and Financial Information. For more updated information, please refer to our 2023 and 2024 articles.

Since many of you currently own or are planning to purchase an IRS Code Sec 529 plan, here are some important ownership, tax, distribution, ownership and investment issues which you need to be aware of:

1. Tax Issues

Parents with sizable balances in their 529 Plans often make the serious mistake of paying the full amount of their qualified education expenses out of it. This could cause you to lose valuable tax deductions and/or tax credits. To qualify for the American Opportunity Tax Credit, for example, requires that $4,000 be used from income.

2. Tax Advisor Issues

Since you are required to pay a portion of your qualified education expenses from income, we suggest you work with your CPA in your base years to make sure you tax full advantage of your tax breaks.. It is important, however, that your tax advisor is well versed in college funding.

3. Distribution Issues

A careful reading of the article in a recent Wall Street Journal article argues for making distributions payable to your student rather than to either the parent or the school. Though making distributions payable directly to yourself or your student may risk an inquiry from the IRS, that risk is much better than the risk of a college deciding to treat your distribution the same as they treat a 3rd party scholarship! Some colleges using the Institutional Methodology may treat these distributions as student income.

4. Ownership Issues

A student-owned 529 is always considered a parent asset under the Federal Methodology.  It can still be problematic, however, if your child ends up going to a school that uses the Institutional Methodology.  That’s because under this methodology some schools will treat it as a student asset.

Grandparent ownership is the worst option since distributions paid directly to the college are considered untaxed income to the student and would overwhelm any benefits you could possibly receive from the 529.

5. Investment Issues

It’s always best to start a 529 plan early in your student’s life. By starting early, the higher internal fees within the 529 are easily offset by the tax-free gains over time.

Starting your 529 just a few years before college doesn’t accomplish much simply because your 529 investments should be held in very low-interest fixed return investments once your child approaches college age.

Most 529 Plans automatically reallocate 80% of your portfolio into these fixed-return investments once your child reaches the age of fifteen. Though you can sometimes opt-out of this reallocation, that’s also not a wise decision because you shouldn’t take any risk when you are only a couple of years from the start of college.

Jim Kraiss has been a Certified Financial Planner (CFP) for over 29 years. He has taught financial planning at several area colleges, written multiple financial planning articles, and authored five books on the subject. With his expertise in designing non-assessable financial instruments for college funding and his previous long-term experience as a Series 7 and Series 63 securities advisor, he has been able to design unique multi-advantaged solutions for our clients.

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