Qualified Tuition Programs, a.k.a. “529s” are a great way to save for college, but like anything involving the IRS, getting the most out of a 529 can be, well...challenging. Contributions to 529s grow tax free, just like Roth accounts, and in most cases, they’re a slam dunk. The problem? The plans are sponsored by the individual states, and each state has its own rules. That’s 50 sets of rules, plus the federal ones, on top of the federal rules for financial aid. All of that complexity has created a few pitfalls and unintended consequences. Here are some of the most common ones and how to avoid them:
Missing out on the state tax deduction.
That’s the deduction you get when you contribute to a 529,. not the benefit that allows your contributions to grow tax-free over time. Some states with income tax like Virginia let you deduct some or all of your contributions and some like California don’t. You can enroll in a plan sponsored by any state, but some states with income tax require that you use an in-state 529 to qualify for the deduction (New York), and some don’t care (Pennsylvania). Check your state’s plan before you enroll. If you’re moving from one state to another, compare 529 plans for the 2 states. It may be advantageous to coordinate your 529 contributions with your move.
Getting hit with the grandparents tax.
It’s great that anyone in the family (actually, anyone at all) can set up a 529 and designate your child as beneficiary or contribute to your 529. But, if your child is eligible for need-based financial aid, you can be penalized when you use those contributions, to the tune of 50%. This is the grandparents tax. If a grandparent contributes $10,000 to a grandchild’s education expenses, you can expect to see a $5,000 reduction in need-based financial aid for the following year. That’s because payments of college expenses made from outside the immediate family -- including from 529s -- are considered unearned income for the student, for financial aid purposes. This unearned income reduces the student's need-based financial aid calculation for the following year. To avoid this trap, plan to take a grandparent’s distributions in the final year of college. Alternately, a grandparent can give money directly to the parents so the parents can contribute it to their 529.
Note to divorced parents: 529 distributions from the non-custodial parent are also counted as unearned income for the student and can reduce the student’s need-based aid.
Over-funding the 529.
This can happen for any number of reasons. For example, you get a new job and your child becomes eligible for an employer scholarship, or your child gets a merit-based scholarship or decides to attend a cheaper school. As a result, there’s more in the fund than you need. It’s a nice problem to have, but now your money is marooned in the 529 unless you can make another family member the beneficiary. To limit this risk, you can build up your 529 gradually rather than with 1 or 2 large contributions, so that you can adjust your contributions as circumstances change. If you have more than one child, you can weight contributions towards the oldest and change beneficiaries if there’s a surplus in the plan.
Despite their complexity, 529 plans are an excellent way to save for college, not least because they commit you to setting the money aside. And that feels good...I always felt satisfied when I put money into my kids' 529s. Just avoid the pitfalls. Check your state’s plan. And when making decisions involving your taxes, always -- I mean always -- consult a tax professional.
Dan Ellentuck, known as College Fin Aid Dad, blogs on college financing and other personal finance topics. The experience of applying for financial aid for his two sons inspired this piece.