For many, welcome to the sandwich generation, those that are effectively “sandwiched” between the obligation to care for their aging parents – who may be ill, unable to perform various tasks or in need of financial support – and children, who require financial, physical and emotional support. The trends of increasing lifespans and having children at an older age have contributed to the sandwich generation phenomenon. Nearly half (47%) of adults in their 40s and 50s have a parent age 65 or older and are either raising a young child or financially supporting a grown child (age 18 or older). And about one-in-seven middle-aged adults (15%) is providing financial support to both an aging parent and a child.
In this article, I’d like to discuss the impact of funding for college and some strategies related to funding for that important financial burden. Let’s call this “”Big Bite #1” relative to the Sandwich Generation. One of today’s most important college savings and fund vehicles is the Section 529 Plan, created in 1996, the name relates to the specific section of the Internal Revenue Code. The plan may either be operated by a state or an educational institution and it may be of two types, a prepaid tuition plan or savings plan.
The advantages are compelling since earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, room and board. Recently the purchase of computer technology, related equipment and/or related services such as internet access as long as usage is during any of the years the beneficiary is enrolled at an eligible educational institution are also considered qualified expenses. Many states offer state income tax deductions for all or part of the contributions or other benefits, such as matching grants, but you may only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence. Just a few states, Pennsylvania included, allow residents to deduct contributions to any 529 plan from state income tax returns.
Another benefit is the flexibility in changing beneficiary as there are no tax consequences if you change the designated beneficiary to other qualified members of the beneficiary’s family as long as funds are rolled over within 60 days of distribution. In addition, plans generally have a very low minimum start-up and contribution requirement. The fees, compared with other investment vehicles are generally low, although this varies on a state by state basis. Importantly, everyone is eligible to take advantage of a 529 plan and the amounts that may be put in are substantial (exceeding $300,000 per beneficiary in many states plans). Also of consequence, is that beginning July 1, 2009, assets held in either type of 529 plan will be treated similarly for financial aid purposes. Assets will be treated as parental assets in the calculation of the expected family contribution toward college costs. An unusual advantage of the assets in a 529 plan, although they could be reclaimed by the donor (subject to income tax and a10% additional penalty for distributions that are not used for qualifying expenses) is that assets are not counted as part of the donor’s gross estate for estate tax purposes. The ability to move assets outside of one’s estate while still retaining some measure of control if the money is needed in the future then becomes a highly unique estate planning tool. An added benefit is the ability to “accelerate gifting.” Typically used by grandparents, 529 plans, offer an additional excellent estate planning advantage in the form of accelerated gifting. Individuals may make a lump-sum gift to a 529 Plan of up to $70,000 in 2017 ($140,000 for married couples) and avoid federal gift tax, provided a special election to treat the gift as having been made in equal installments over a five-year period and no other gifts are made to that beneficiary during the five years.
Aside from the numerous advantages listed above there are certain disadvantages potential “pitfalls”, or strategies and that an investor needs to be mindful of, as follows:
POTENTIAL DISADVANTAGES & PITFALLS:
- Relative to managing the allocation, unlike other tax-deferred plans, IRS rules only allow two exchanges or reallocation of assets per year in a 529 plan.
- The earnings portion of withdrawals not spent on eligible college expenses will be subject to income tax, an additional 10% federal tax penalty and the possibility of recapture of any state tax deductions or credits taken. (There are certain exceptions to this, such as transfer to another qualified designated beneficiary, disability of the beneficiary or other.)
- Paying tuition directly from a 529 account may reduce a student’s eligibility for need-based financial aid.
- Paying college expense directly from a 529 account may also reduce eligibility for the American Opportunity Tax Credit. In addition to meeting other criteria such as income limits, $4,000 of college expenses per year should be paid from non-529 funds.
- Since 529 plans are offered state by state, plan expenses may vary widely and plans are not required to disclose their expense ratios in marketing materials. Expenses are an important consideration to be weighed against other advantages certain state plans may offer such as professional financial advice and credit card rebate programs.
- Assets owned in an account by a dependent student or one of their parents are considered parental assets on the Free Application for Federal Student Aid (FAFSA), meaning that only a maximum of 5.64% of assets are counted vs. student assets which are counted as 20%. However, if the student is not a dependent of the parents for tax purposes (financially “independent”), the student-owned plan is treated as an asset of the student which causes 20% of the account balance to count towards calculations on the FAFSA. With either of the above ownership designations, qualified distributions from the plan are not counted as income for financial aid determination.
- Assets held in a 529 account by a grandparent other relative or anyone else besides the student or parent will not be counted as an asset on the student’s FAFSA.
- With a grandparent-owned 529 plan, assuming the grandparent is not the legal guardian, when distributions are made, it is treated as income of the student, (even though the income is “tax-free” for income tax purposes). This can be a huge negative for financial aid purposes since it would be assessed at a 50% rate of the student’s income above a $6,260 income allowance!
- In coordinating strategies, in light of the current rules concerning financial aid, including those signed by an executive order by President Obama in the fall of 2015, the first key is to recognize the age of the student and when he/she is expected to go to college. For those looking to make gifts to support children many years away from college, funding a grandparent-owned plan will likely be the most appealing, allowing for tax-free compounding for the child. It also begins to shift assets out of the grandparents’ estate which is appealing from an estate planning perspective. (It’s important to recognize that those plans should only be liquidated during the student’s last two years in college to ensure that the distributions don’t have a negative impact on the student’s calculations towards filing the FAFSA.)
- In the early years of college, the grandchild should, most likely, use their own assets or parental assets since distributions for qualified purposes are not included in the “base-year income” that reduces the following year’s financial aid eligibility. In addition to this benefit is the fact that other tactics are extremely detrimental to funding college in their early years due to their impact on subsequent financial aid. In addition, “spending down assets” owned by students and parents, that are counted against financial aid is appealing as it may improve eligibility for college aid later.
Obviously, any of these strategies or potential advantages should be discussed with your tax and/ or financial professional to determine the best course of action for your particular case.
In our next article, we will address “BIG BITE #2” concerning the obligation to care for aging parents.
2016 Department of the Treasury, IRS Publication 970
Irvin W. Rosenzweig, CFP®, ChFC®, CLU®, CRPS®, AEP®
Barron’s Top 1000 Financial Advisors as listed in the February 18th, 2013 edition
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