This was originally published on Sept. 27, 2013. It is part of 12 Days of Wealth Management: The Year in Review.†
With the new school year now in full swing, my clients are focusing on how to save for college and the best way to use their 529 plan dollars. In my conversations, it has become apparent that making any of these five mistakes could cost your clients money, create unnecessary tax bills, and just make you look bad.
1. OVERLOOKING PREPAID TUITION PLANS
There are two types of 529 plans, but the default recommendation for many advisors is just the saving trust, which allows dollars to be invested and grown tax-free, assuming distributions are used for qualified education expenses.
Advisors should take another look at prepaid plans, however. These enable tuition credits to be purchased for partial or full semesters and redeemed at participating colleges. Plans vary (a lot), but the premise remains the same: Tuition rates are locked in at todayís cost. Most states have a prepaid plan, allowing credits to be applied to public state colleges and universities, but there is a plan for private institutions as well.
Given that tuition rates have increased about 6% annually over the last 10 years, and that is expected to continue, this could be a great option for reducing the overall cost of tuition.† The down side is if the student elects to attend a college that does not participate in the plan, then the credits may only cover a very small portion of the tuition cost -- or participants just get their money back. Keep in mind that one can choose a plan that is outside their state of residency.
Prepaid plans are best for clients that have a strong sense of where the student may go to college and are willing to give up market returns for the certainty of locking in the cost today.† A great strategy to maximize dollars for college is to pair a prepaid plan with a savings trust to cover tuition, fees, room, board, and other qualified expenses.
2. GETTING IT WRONG ON BENEFICIARY CHANGES
Beware of the strict rules for changing beneficiaries, which could cause a client to incur taxes or penalties. The new beneficiary must be a member of the family as defined by the IRS, within the same generation (or an earlier one) as the original plan beneficiary, in accordance with gift tax laws.
For example: If a client has money left over from her sonís 529 plan, she may assume she can change the beneficiary to her granddaughter -- but this could trigger an estate tax issue, given that it could be viewed as a generation-skipping gift.
3. MISUNDERSTANDING SCHOLARSHIP OFFSETS
Even if the student does receive a scholarship for any reason, the dollars in a 529 plan are not wasted. Clients have the option to withdraw from the plan the dollar amount of the scholarship. Taxes will have to be paid on the earnings, but the 10% penalty on non-qualified distributions is waived.†
4. FAILING TO REBALANCE CORRECTLY
The IRS allows 529 plans to be rebalanced only once per year, turning any further trades into taxable events that may incur penalties too. Trades to invest deposits or liquidate funds for distribution do not count -- but with such a stiff penalty, advisors must keep careful records and verify when the last trades were placed before taking action.
5. IGNORING TARGET-DATE FUNDS
Investing and managing the dollars in a savings trust can be tricky because time horizon is short and the risk profile changes quickly over time. It could make sense to invest for growth initially and shift to preservation strategies as the college enrollment date gets closer, so the account value doesnít plummet before the first tuition check is cashed.
For advisors who prefer to focus on client service rather than investment management, however, target-date funds are an easy solution. They'll peg the investment allocation to the beneficiaryís expected college enrollment date and automatically rebalance the account accordingly.
Jessica Ness, CFP, is a client advisor and the director of financial planning at Glassman Wealth Services, a wealth management firm in McLean, Va.†