5 key tips for advisors on 529 college savings plans

May 28, 2023 6:00 AM

The education savings plans known as 529s are one of the top ways for families to save for that ever-more expensive college degree — but many Americans still don't know much about them.

Only 34% of American adults correctly identified the plans as educational savings tools, in a new 529 awareness study by Edward Jones. That's the lowest the rate in the annual study has been since 2020, when it was 45%.

With "529 Day" just around the corner, on May 29, advisors have a perfect opportunity to discuss with clients whether the plans make sense for them and how to use them optimally. States, which sponsor the plans, will be celebrating the manufactured occasion with different initiatives aimed at encouraging saving for higher education, typically one of a family's biggest expenses. Edward Jones will also recognize it as "Save for Education Day" at its branches around the country.

"With the current economic challenges we're facing, such as rising interest rates and inflation, many individuals are shifting their priorities from saving for long-term goals to ensure they have enough to cover everyday expenses," Steve Rueschhoff, a principal at Edward Jones who leads Managed Investments and Insurance, said of the new survey results. He added that he wasn't sure of the exact reason for the drop in awareness, but other firm research had shown Americans became more interested in 529 enrollment after learning about the plans' many benefits.

The price of college in America is growing at an estimated annual rate of 7%, and Americans pay more dollars out of pocket for their children's educations than a decade ago. The average cost of college in the U.S. is around $35,551 per student per year, covering tuition, books, supplies and living expenses; and elite private institutions can charge double that.

Expensive school or not, failing to save in advance can be a costly mistake — and one that a 529 plan can play a big role in averting.

A 529 plan, also known as a qualified tuition plan, is a type of tax-advantaged investing account sponsored by a state or state agency or representative. It allows investors to save for future education expenses for someone who is a designated beneficiary — typically, the investor's child — by investing dollars in a plan, then using their compounded value to pay for the beneficiary's qualified educational expenses, such as college tuition or books.

Contributions to a 529 aren't deductible for federal purposes, but qualified withdrawals for school expenses are tax-free. Several states allow deductions for state taxes; among them, Colorado, New Mexico, South Carolina and West Virginia allow a deduction of 100% of the contribution made, according to the Education Data Initiative.

By starting early and relying on the investments to compound over time, the accounts can grow sizably over the years through regular contributions. The plans don't have annual contribution limits; lifetime contribution limits for a beneficiary vary by state, but range from $235,000 to $569,123.

There were over 16 million 529 plans as of the end of 2022 — a more than 50% increase from 10.1 million in 2009, according to the College Savings Plans Network, an affiliate to the National Association of State Treasurers. That number is a new record high, the network said, and it represents $411 billion of total assets.

"We do see this as an opportunity for financial advisors to initiate these conversations with clients, especially as we are in the height of graduation season and approaching back to school," Rueschhoff said.

Amid recent legislation, there's all the more reason to make full use of a 529. A provision in the second Setting Every Community Up for Retirement Enhancement Act, known as SECURE 2.0, will allow Americans come 2024 to convert unused 529 money into a Roth IRA for the beneficiary, up to a lifetime maximum of $35,000. Roth plans are funded with after-tax dollars, and their withdrawals are tax free.

The 529 account has to be open for at least 15 years before being rolled into a Roth IRA. Contributions and growth from the past five years can't be shifted over, and annual contributions to the Roth IRA would be subject to the usual IRA contribution limits of that year.

If 529 dollars are used for non-educational expenses, the account owner owes federal and state taxes, as well as a 10% penalty, on the earnings withdrawn. Previously, if a saver was stuck with money in an account because their child didn't go to college, the only way to get the funds out was to pay the tax bill.

Financial Planning spoke with several advisors on common challenges they see when helping clients with 529 plans. Here are five, and tips on how to address them.

Kids who don't want to attend college

"The most common pushback I hear from clients is, 'what if my child doesn't go to college?'" said Carl Holubowich, principal and financial advisor at Armstrong, Fleming & Moore in Washington, DC.

There are other savings vehicles, such as certificates of deposit or high-interest savings accounts, that a client could use instead. But 529s have more flexibility than a client might think. "You can change the beneficiary to another family member, potentially creating an educational legacy for your grandchildren even if they aren't born yet," Holubowich said.

Clients who qualify could also exercise the Roth IRA rollover benefit starting in 2024, Holubowich said, or "take the funds back as a non-qualified distribution or simply pay it out to the beneficiary."

If clients get antsy about the concern that the child might not attend college, "I explain that they can take the money out without penalty if the student receives scholarships or that they can change the beneficiary to another child," Mike Hunsberger, the owner of Next Mission Financial Planning in Saint Charles, Missouri, said in an email.

Alternatively, 529s can pay for a "vocational school, or other postsecondary educational institution" that qualifies, or up to $10,000 per year for a beneficiary's k-12 expenses at qualified schools, according to the Internal Revenue Service.

Using 529s to pay for private school

Another challenge arises when clients use 529s to fund K-12 private school, according to Jamie A. Bosse, a financial planner at Aspyre Wealth Partners and author of the personal finance book "Money Boss Mom."

"In theory, it's great to be able to funnel the tuition through the 529 plan, get the tax deduction for the contribution (if your state allows), then pull it right back out to pay your private school tuition," said Bosse, who specializes in working with young parents. Since the pandemic, many private schools have seen a rise in enrollment. "However, some plans make this difficult."

"Ideally, if you're taking the funds right back out, you don't want them invested — it's better to keep them in a money market-type holding."

Client fears of overfunding 529 plans

Clients also fear overfunding these plans, Bosse said.

"People tend to view 529s as 'use it or lose it' type of accounts. They think they lose out on the money if their kid doesn't go to college, or gets a full ride and doesn't need the funds – and that is simply not true."

If a child doesn't use up their 529 funds, advisors can encourage clients to transfer the leftover money to another child in the family or a relative who needs it. They could also make themselves the beneficiary, if they are planning to take classes at a local community college for instance, Bosse said.

The money could also be rolled into a Roth IRA for the child, or turned into a legacy account for use by grandchildren someday as beneficiaries, Bosse said.

Leftover dollars can be used to help pay off student loans for the child or other family members. In the worst case scenario, the investor could just cash out for a "non-qualified" reason and pay the tax. But even in that situation, taxes and penalties only apply to the gains in the account, not to the total balance, so "it's generally not a huge deal," Bosse said.

Paying tuition directly from the 529 account

This is a no-no, according to Benjamin Andrew, a client analyst and financial advisor at Laird Norton Wealth Management in Bellevue, Washington.

"Oftentimes, if you opt to send the funds directly from a 529 account it will mail a check to the institution which can get held up in their administrative process," Andrew said. Schools can take more time to receive and process a paper check and apply it to the account, which might risk holding up the student's ability to register for classes.

Andrew said he had found it easier for clients "to just pay the tuition (or) school expense" from their bank account, then reimburse themselves from the 529 account, Andrew said. "You can do this by having the check sent to you directly and depositing it at your bank."

Starting late or not starting a 529

Brandon Gibson, a wealth manager at Gibson Wealth Management in Dallas, said the key is to start as early as possible, because "the special benefits of the 529 apply to the growth."

He said he started his own daughter's 529 three months before she was born and changed the beneficiary from himself to her once she was born. "I also made sure her grandmother, great grandmother and great aunt had the address and account number," Gibson said.

For his daughter, he added, that was useful information: "Every birthday and Christmas, she gets contributions from extended family in addition to what I am putting in there."