A series of strategies for tax-wise investors. Table of Contents
529
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Earnings on a college savings account escape income tax if withdrawals are used for the right purposes (including tuition, room and board). There is also an estate-tax angle: A grandparent can preclaim five years of gift tax exclusion to park $75,000 per youngster in college savings. That gets the money out of the grandparent’s estate, provided this person lives five years, while leaving the grandparent with some wiggle room to take the money back later.
Another benefit is that many states subsidize these accounts by handing the donor an income tax credit or a deduction for contributions.
The fancy footwork here relates to how the accounts interact with financial aid formulas. If, as in the typical arrangement, the account owner is the parent, the aid office treats it as other family assets, like a bank account balance; in that case, roughly 5% of the balance gets dinged every year via reduced aid. If a grandparent owns the account, it’s usually withdrawals, not balances, that are assessed and the damage is worse.
One defensive maneuver is for a grandparent to own the account and play switcheroo with beneficiaries. Let’s say the intended beneficiary is Sally, soon headed to college. Grandpa names Sally’s 8-year-old cousin as beneficiary, meaning the money appears nowhere on any balance sheet of Sally or her parents. Just in time to pay for Sally’s senior year, Grandpa switches the beneficiary to Sally and disburses the money. The disbursement comes too late for the financial aid officer to take it into account as a reduction in need-based aid.
Some care must be taken to plan around unforeseen events (like Grandpa’s demise), and to work with restrictions on account changes (some state plans impede changes in ownership or beneficiaries, or forbid transfers to another state plan). The right strategy means keeping perhaps tens of thousands of dollars away from the college bursar’s claws.
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There is a penalty for not using a 529 for education: Earnings are subject to ordinary income tax plus a 10% penalty. In emergencies (for example, the account owner takes the gift back to cover a nursing home bill), that penalty is tolerable. Bear in mind that the penalty applies to the earnings, not to the full withdrawal, and that without the 529 the earnings would have been taxable anyway.
Section 529 of the tax code is a plaything of the privileged, and there have been suggestions about curbing the tax benefit. But the idea of putting on new restrictions hasn’t gotten far. There are just too many voters who like these accounts.
Also, Democrats have been talking about forgiving college debt. How well would it go over for the Biden administration to penalize families that scrimped and saved for college while offering handouts to families that didn’t?