Benjamin Franklin famously said, “The only thing more expensive than education is ignorance.” I’m not so sure Benjamin would feel the same way if he saw today’s college tuition fees. I would probably have to place the cost of ignorance a bit lower these days—at least for some schools. Take Sarah Lawrence College in Westchester as an example. Tuition and fees are a whopping $80,000 per year now. This means you probably have to gross around $110,000 before taxes to pay for one year of college there. What’s interesting is that the median starting salary of its graduates is $42,600. So after you pay your taxes, you’d have to work for three years and pay for nothing else just to afford one year of your education.
By planning ahead and taking advantage of a big tax break, you can give your college savings a much-needed boost. In this article, we’ll discuss how a 529 plan can make paying college tuition a little less painful. The main advantage to the 529 is that you can use tax-free earnings to pay tuition. This means less tax and costs you less money out of your pocket to fund Junior’s education.
Before we dig in, some may be wondering what exactly is a 529 plan? Google so eloquently defines it as, “an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996.” Essentially, it’s a savings plan you set up specifically for a designated beneficiary to use for college costs.
How the 529 Saves
The way the 529 plan works is as follows: (1) You fund the 529 with post-tax dollars. (2) The funds can grow completely free of tax. (3) Withdrawals for qualified tuition expenses are tax-free.
The 529 is funded with post-tax dollars and you do not receive a tax deduction for contributions—at least at the federal level. You may have heard something about getting a tax deduction for contributing to a 529. Well, that’s not always the case, and definitely not in New Jersey. If you contribute to a New Jersey 529 plan, our stingy state doesn’t allow a tax deduction on your New Jersey tax return. You may contribute to a New York plan and get a small deduction on your New York tax return if you file there, but any savings on your New York return may be canceled out on your New Jersey tax return. This is because when you file your New Jersey return, you get a credit for taxes paid to New York. But if your New York taxes are lowered then your credit that flows to your New Jersey return is lowered as well.
The enticing thing about the 529 is the tax-free earnings. Think about it; if you put $10,000 into a 529 plan when your child is 3 years old, you will have 15 years of growth on this amount. That $10,000 may turn into $30,000 with some savvy investing. You don’t pay a dime in taxes on either the $10,000 you put into the account or the $20,000 of earnings. On the flip side, if you invested that $10,000 in a taxable brokerage account, you would have to pay as much as $4,000 in capital gains taxes on the earnings.
Qualified Expenses
In order for the withdrawals to be tax-free, they must be used only for qualified expenses. Fortunately, tuition is not the only expense it can be used for. You may also use the funds to cover books, supplies, school fees and even room and board.
Contributions and Gift Tax
For gift-tax purposes, contributions to 529 plans are taxable gifts eligible for the $14,000-per-donee annual gift-tax exclusion (2017 amount), which doubles to $28,000 if your spouse contributes as well.
The tax code contains a special option for 529 plans that allows you to spread the contribution over a five-year period so as to take advantage of the $14,000 annual exclusion. For example, you can contribute $70,000 to the 529 plan and use five years of the $14,000 exclusion to avoid any gift taxes. You and your spouse with combined consent could contribute $140,000 and use the five-year rule to avoid gift taxes.
Financial Aid
One negative to the 529 plan is that any funds in the account, whether you or your child own the account, do count against you and your child when figuring the financial aid you and your child would qualify for.
By Daniel Magence, CPA, Esq.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether it’s tax returns, bookkeeping, payroll services or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
