By Susan Brown, Principal
529 education-savings accounts have gained popularity in recent years due to the steep increase in college tuition costs. According to the latest data from the College Savings Plans Network, assets in 529 accounts grew to $275 billion in 2016 from $106 billion a decade earlier. The primary benefits of 529 accounts include no income tax on investment gains, tax-free withdrawals for qualified expenses, and tax deductions on contributions in some states. Prior to 2018, 529 accounts could only be used for higher education expenses (i.e. tuition, books, room and board, etc.); however, provisions in the Tax Cuts and Jobs Act expand the use of 529 accounts to include elementary and secondary school tuition up to $10,000 per year. There is no annual limit on the use of 529 accounts for higher education expenses. Given this change, an obvious question emerges for families whose children have existing 529 accounts:
SHOULD I BEGIN USING MY CHILD’S 529 ACCOUNT FOR THEIR PRIVATE ELEMENTARY AND SECONDARY SCHOOL TUITION?
Consider the following scenarios.
Scenario 1: Your child is entering kindergarten and has a 529 account with a balance of $100,000. If the account earns 6% annually and there are no withdrawals during their elementary and secondary years, the account balance would be around $213,000 upon high school graduation. Assuming the same growth rate and an annual withdrawal of $10,000 from kindergarten through twelfth grade, $130,000 would have been spent, and the remaining account balance would be $13,000 when they enter college. Therefore, not utilizing the 529 account before college results in $70,000 of additional tax-free growth.
Scenario 2: Your child is entering sixth grade and has a 529 account with a balance of $150,000. If the account earns 6% annually and there are no withdrawals during her secondary education years, the account balance would be approximately $225,000 when she graduates from high school. Assuming the same growth rate and an annual withdrawal of $10,000 from sixth through twelfth grade, $70,000 would have been withdrawn and the remaining account balance would be $136,000 upon high school graduation. In this scenario you would have earned an additional $19,000 in tax-free growth by waiting until college to utilize the funds.
As shown in the graph, both scenarios suggest the same conclusion – keeping funds in 529 accounts until college is the best option to maximize dollars available for education expenses. The simple reason is the power of compounding. Compounding occurs when an account generates appreciation not only on the original investment, but also on capital gains, interest, and dividends earned over time. This effect allows your money to grow faster and faster as the years roll on. While you are generally better off waiting to use 529 funds for college expenses, each situation is different and various factors (i.e. a sizable 529 balance that would not be fully utilized in college, income tax consequences to raise cash for elementary and secondary tuition costs, etc.) may make using the 529 fund earlier an appropriate decision.
MY CHILDREN DO NOT HAVE 529 ACCOUNTS. SHOULD I BEGIN CONTRIBUTING?
Establishing 529 accounts for your children at an early age is advantageous for most families. For families of substantial means, the analysis is different when factoring in estate planning considerations. 529 accounts are generally not the most effective way to fund education expenses because of the annual gift tax exclusion. The annual gift tax exclusion is the amount each person may give annually to individuals without incurring gift tax or using lifetime exemption. For 2018, the amount is $15,000 per person. 529 contributions count towards the annual exclusion amount, whereas direct tuition payments are not considered a gift and do not use annual exclusion. Given this difference, the annual exclusion is essentially wasted when used for 529 contributions. Over the long-term, funding children’s elementary and secondary school tuition outright AND making annual exclusion gifts to them is more powerful estate planning than contributing to a 529 account. Annual exclusion gifts can be made directly to a child or to some types of trusts where she is a beneficiary. The St. Louis Trust Company and your estate planning attorney can assist in analyzing the best options for your family.