The Pitfalls of 529 Plans

529 Plans are somewhat confusing because they are subject to Internal Revenue Code qualification requirements but are operated by the various states or educational institutions under varying operational policies defined by them. 529 Plans established by the states come in two basic formats: (a) prepaid tuition plans and (b) savings plans. Eligible educational institutions can establish plans, but they can only be the prepaid tuition type.

A prepaid tuition plan is a way to lock in the price of covered educational services at today’s prices at a particular educational institution, thus insuring against college cost inflation. There is no upside return. For some folks, just keeping up with college cost inflation is enough, since college costs have been rising two to three times the rate of inflation.

In contrast, a savings plan is best thought of as a tax-advantaged way to build up a college fund. Savings plans do not lock in the cost of covered educational services. However, there is the potential for a higher return. Nevertheless, two recessions and bear markets in the last ten years have seen savings plans underperform, even lose money.

To date, 529 Plans have been established by all the states. Additionally, the Independent 529 Plan was established in 2003. These plans vary greatly in terms, fees, managers, performance, contribution limitations, and other details and conditions.

All 529 Plans must meet the Section 529 qualification rules. Beyond that, plan terms can vary widely. Each specific plan must be analyzed in terms of the client’s needs and goals. Adding to the complexity of this task is the fact that most savings plans are now open to out-of-state residents. State-sponsored 529 Plans are not required to get formal approval from the IRS before operating a program; nevertheless, many states have requested and received private letter rulings ensuring the tax qualified status of their plans.

The Financial Aid Pitfall

When looking at how distributions from and asset values of 529 plans might affect financial aid, there are two ways in which financial aid will be affected. First, if either the parent or the child is the owner of the 529 plan, the plan will be assessed as the asset of the parent, meaning financial aid will be reduced by up to 5.6% of the asset value of the plan on the date the Free Application for Federal Student Aid is filed. Second, distributions for the plan to pay for college will be considered a resource and will reduce financial need dollar-for-dollar. Of course, if the parents do not expect to receive financial aid, this pitfall is not a concern. In fact, 529 Savings Plans tend to be a favorite of more well-to-do families, and particularly grandparents where estate reduction is important. Incidentally, it is well-known that 529 Plan assets are not assessed by financial aid formulas when they are owned by grandparents.


The Nonqualifying Distribution Pitfall

The tax-free treatment of qualified distributions gives 529 plans a definite advantage over UGMA/UTMA and trust accounts. But the tax-free treatment is lost if the distribution is not qualified and there may be a 10% penalty on the earnings amount if the distribution does not fall under certain exceptions.

A distribution is tax-free is the expenses are qualified. Qualified expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Reasonable room and board are treated as qualified expenses only if the student is at least half-time and they do not exceed the amount the institution uses in their cost of attendance calculation or the amount actually charged the student, whichever is greater. Any other expense paid or covered by a distribution from a 529 plan in a particular year will be considered nonqualified.

How to parents get trapped? Let’s say John and Mary Smith pay $36,000 of college expenses for their daughter Sally for the academic year 2009-2010 and these expenses include personal expenses of $3,000, clothing $1,500, and airfare of $1,500. These are disqualified expenses and the earnings on this “extra” $6,000 will be taxable and subject to the 10% penalty.

The Tax-Free Benefit Pitfall

Certain withdrawals, assistance, grants, or scholarships reduce the amount of qualified expenses that can be treated as tax-free. In other words, tax-free benefits actually cause distributions of 529 plans to be taxable. Most parents are unaware of this. The categories of tax-free benefits which cause 529 plan withdrawals to be taxable are as follows:

1.)    Withdrawals from Coverdell Education Savings Accounts
2.)    Non-taxable scholarships
3.)    Pell grants
4.)    Veterans education assistance
5.)    Selected reserve education assistance
6.)    Employer Education Assistance Plan payments under IRC 127

Let’s look at an example of how this would work in practice. Suppose John and Mary Smith are facing a potential $30,000 of college expenses, covering all of the qualified expenses and none of the unqualified types. However, John and Mary decide to first use $6,000 from the Coverdell Education Savings Account. Therefore John and Mary Smith only have to pay the college $24,000 with a 529 plan withdrawal. But if use the $6,000 to cover the unqualified expenses, and do a 529 Plan withdrawal of $30,000, a portion of the $30,000 withdrawal will be taxable. The result: 20% of the earnings attributable to the $24,000 529 withdrawal will be taxable ($6,000/$30,000 times the earnings attributable to $24,000).

The 10% Penalty Pitfall

In addition to any tax on earnings attributable to unqualified expenses paid by 529 Plan withdrawals, a 10% penalty in also imposed on such earnings with the following exceptions:

1)    a distribution on account of a beneficiary who is dying or is disabled
2)    a qualified scholarship
3)    an educational assistance allowance
4)    other nontaxable payments as defined in IRC Sec. 25A(g)(2)
5)    expenses that otherwise qualify for education credits
6)    payments to the US Military, Naval, Air Force, or Coast Guard Academys

Note that these exceptions do not change the taxability of the earnings attributable to the 529 withdrawals for unqualified expenses. Earnings on the 529 plan withdrawals are still taxable even if any one or more of the six exceptions mentioned above are involved. One of the most common is the qualified scholarship. If a 529 plan withdrawal occurs in the same calendar year as receipt of a scholarship, a portion of the earnings on the 529 withdrawal will become taxable.

Assume this time that John and Mary Smith withdraw $30,000 from the 529 Plan. Cost of attendance is still $36,000, including $6,000 of personal, clothing, and air transportation. Sally receives a $6,000 scholarship from an independent third party, not the college. Sally uses the scholarship to pay tuition. John and Mary Smith will be taxed on 20% of the earnings portion of the 529 Plan withdrawal ($6,000/$30,000 x the earnings)

The Tax Credit Pitfall

A student or the student’s parents may claim an education credit for qualified tuition and expenses. However, the same qualified expenses cannot be used to claim both a education credit and tax-free 529 Plan withdrawal. Therefore, the amount of qualified expenses to be taken into account for determining the 529 Plan withdrawal must first be reduced by the qualified expenses used to determine the education credits.

This trap is so easy to fall into. Take the example of John and Mary Smith. If they try to claim an education tax credit, assuming either they or Sally is eligible to do so, they will cause a portion of the 529 plan earnings attributable to the withdrawal to become taxable.

The 529 Plan-Account-Owned-by-Grandparents Pitfall

Every financial advisor, CPA, and tax planning attorney worth his or her salt recommends that grandparents own the 529 Plan account because the account is not assessed as an asset of the parents in the financial aid formulas. That benefit is primarily why this advice is out there in the market place.

There is a pitfall. If the student is eligible for financial aid, the withdrawals from a 529 Plan account are treated as a resource, meaning that they reduce financial need dollar-for-dollar. So in a situation where the student has financial need, a better strategy might be to wait until the senior year to make 529 withdrawals. If the student will not have financial need, then the grandparent ownership is not a pitfall.

The Loss Provision-Some Pitfalls

Penalties and taxes on the earnings portion of a 529 Plan withdrawal apply when there are earnings. But what if the 529 Plan account has a loss, resulting from the recent devastating bear market? The account owner may claim the loss as a Miscellaneous Itemized Deduction, subject to the 2%-of-AGI limitation. Penalties and taxes would not apply. Internal Revenue Service Publication 970 is supposed to contain the rules regarding education expenses, credits and 529 Plans. However, it is vague on claiming losses. Taxpayer beware.

A loss is realized only when the funds are completely withdrawn from the 529 Plan accounts. So the first pitfall would be trying to claim a loss on a partial withdrawal.

When funds are reinvested in another 529 Plan account within 60 days of a withdrawal, the reinvested funds are considered a rollover. So, the second pitfall would be to inadvertently invest funds in a 529 Plan account, forgetting that a withdrawal from a loss account had been made within 60 days of the investment in another 529 Plan account. The loss would not be allowable.

Some states allow a deduction for 529 Plan contributions. Those same states may require withdrawals for unqualified purposes to be included in state income. Since many states peggy-back on the federal tax return, this item may be missed when there is a withdrawal on a loss account.

Limited Investment Decisions

A 529 Plan account owner can change the investment option or asset allocation only once per year. How much damage did that cause in 2007 when the bear market started? Or how much portfolio performance was lost when the recovery started in March 2009? This is one major reason why taxable brokerage accounts and Uniform Transfers to Minors Act custodial accounts have an advantage over the 529 Plans. These accounts give the owner complete investment control and in addition, decision-making ability over when to realize gains if individual stocks and/or ETFs are used. As indicated above, the various pitfalls have adverse tax consequences.

Investment and asset allocation decisions can be affected by using new contributions to new accounts and by using a rollover from one state plan to another for the same beneficiary. Many 529 Plans offer age-weighted investment options where the manager affects asset allocation decisions at various ages, varying from growth while the child is young to income when the child is high school age. Naturally, these age-weighted allocation changes are nontaxable transactions which can’t be done without tax consequences in a taxable brokerage account.

The Gift Tax Trap When Skipping a Generation

When a child decides not to go to college and there are no remaining siblings who are in or planning to go to college, the 529 plan may be in danger of incurring a tax if the monies are disbursed for nonqualified expenses. A parent may decide to wait and change the beneficiary to a grandchild. The trap here is that the child, now a parent, is deemed to have made a gift to his or her child, the grandchild of the first parent. If the account is more than the annual gift tax exclusion ($13,000 in 2009), the child will be using up a portion of the lifetime gift tax exclusion.

Differing State Restrictions

529 Plans are not alike from state to state. While fees, investment managers, minimum contributions, state tax deductions, and maximum balances can differ, plans can also differ as to specific provisions. It is very important to get the materials and read them carefully. Unique features or restrictions can present problems, especially if they are discovered after the plan setup.

Poor Investment Performance

The inflation rate for college costs has run at a multiple of 2 to 3 times the Consumer Price Index. Room, board and tuition in 1960 was approximately $1,500 per year at Ivy League colleges. Today, the cost is over $45,000. That represents a rate of inflation of 9.1%. In 1986 the room, board and tuition at instate 4-Year public institutions was $4,138. In 2006 the cost was $12,805 (the cost is much higher for out-of-state students). That represents a rate of inflation of 5.8%. Private institutions experienced a rate of inflation of 5.4% between 1986 and 2006. Why the difference between private and public? A couple of reasons. The ivy league colleges decided to price their cost of attendance high so that families would perceive the value. They also had to expand buildings, equipment, and professorships, including sports facilities, to compete and accommodate the increase in enrollment. On the other hand, public institutions probably obtained some financing through taxes and municipal bond issues. They also are subject to constraints imposed by taxpayer representatives in the various state houses.

This indicates that an investment in a 529 plan should be returning at least 6%. Unfortunately, the performance record leaves much to be desired.  Vanguard’s 529 plans started in 2002. The 529 plan fund with the highest return since December 2002 to March 31, 2009 was Vanguard Inflation-Protected Securities Portfolio with a return of 3.51%. The regular retail fund by the same name, established outside of 529 plans, started in 2000 and the return since inception through July 31, 2009 was 6.97%.
The earliest Fidelity’s 529 plans started from 1999, and those were the aged portfolios. None of those had returns since inception of more than 1%.  The Fidelity 529 plan with the highest return was the Intermediate Treasuries Index 7.27% from October 2006 to June 30, 2009. Returns were down from there, the 12.23% loss on the Total Market Index being the worst.

In summary, without researching other money managers, it is safe to conclude that asset allocation with 529 plans should be done with great care.

When 529 Plan Investments Make Sense

Investments in 529 Plans make sense in the following situations:

1)    Grandparents can invest for grandchildren without affecting their financial aid and get an estate tax benefit,
2)    Contributions are limited so as to fund only qualified expenses,
3)    Contributions are started preferably while the child is pre-school age,
4)    It is desirable to maintain control over the funds, not provided by UGMA/UTMA, accounts that become assets of the child at majority age,
5)    Flexibility and control is desired for changing child beneficiaries,
6)    To take advantage of the five-year spread gifting option in order to contribute up to $65,000 per parent to a 529 plan ($130,000 if spouse joins in the gift),
7)    To take advantage of tax-free benefits, especially in a environment of increasing tax rates,
8)    To take advantage of low minimum startup contribution, lower than that of most mutual funds,
9)    Parents can start saving early and contribute very small amounts,

The 529 Plan can be used in conjunction with other strategies, such as retaining a taxable account in the name of the parent, setting up a UTMA custodial account, having grandparents pay tuition directly to the college (avoiding gift-tax consequences), setting up a self-employed business and hiring the child, and setting up trusts. With split strategies, care should be taken not to overfund the 529 Plan.