As summer begins, many parents wonder how best to pay for higher education. We asked experts to help answer reader questions on college savings, in particular “529” plans, the tax-advantaged savings accounts that invest in mutual funds.
Q: Years ago, we and my parents saved for our children’s college tuition by purchasing savings bonds. Is this still a good strategy? I like the idea of buying this type of “gift” for them, tucking it away, and then years down the road having it available to use either for schooling or other large-ticket items. Also, what is the procedure for moving interest from U.S. Treasury savings bonds (I & EE) into a 529 to avoid taxes?
A: Yes, you can use savings bonds to save for college, but using a 529 account is a better idea, says Mary Morris, CEO of Virginia’s state 529 plan. Experts generally point to 529 accounts as the most tax-efficient way to save for college.
While Series EE bonds issued after 1989 and all Series I bonds can be used to pay tuition and fees, if you instead open a 529 account for your student, that money can be used for a long list of allowed expenses on top of tuition and fees: textbooks, supplies and equipment, computer equipment, peripherals, software and internet access, special-needs expenses, and room and board (if enrolled at least half-time), she says. And while your savings bonds will provide a safe, steady return, a 529, in which the money you’re putting away is usually invested in stock and bond funds, will likely yield more. Unlike savings bonds, 529 plans also don’t have limits on how much income you can earn before you’re no longer allowed to contribute, Ms. Morris says.
You can’t deposit the interest from a qualifying savings bond in a 529 without tax implications, but you can sell a Series I bond or a Series EE bond issued after 1989 and put the proceeds into a 529 under certain circumstances, Ms. Morris says. To do so, you have to hold the bond in your name or jointly with your spouse; be age 24 or older before the bond issue date printed on the front of the bond; not be a married-filing-separately taxpayer; meet the requirements for modified adjusted gross income (check out IRS Publication 970 and Form 8815 for the details); deposit the money you get from redeeming the bond in a 529 within 60 days; and report the exclusion on Form 8815.
Q: If a grandparent makes a tuition payment directly to the college, does it count as part of the annual gift-tax allowance?
A: “A grandparent’s payments made directly to a school for tuition may be excluded from a gift-tax standpoint, but may affect future need-based financial aid,” says Kevin Cox, head of government savings at Ascensus, which runs 529 plans for states. Also note that the payments a grandparent makes may not be eligible for the American Opportunity or Lifetime Learning tax credits, he says. In other words, you can’t get the tax benefits of a 529 and get a tax credit for the same expenses.
You may want to consult the IRS rules on gift taxes (look for Instructions for Form 709) for a detailed explanation, Ms. Morris says.
Q: My granddaughter begins college this summer and is receiving financial aid. If I use the 529 I own to write a tuition check, will that affect her financial aid?
A: Yes, most likely. “Many grandparents use their funds in the later years of a beneficiary’s education to minimize the impact on need-based financial aid,” Mr. Cox says. That is because the Free Application for Federal Student Aid, or Fafsa, considers the family’s finances from two years before the student files the form to see money that a student is receiving, such as withdrawals from a grandparent-owned 529, and counts those withdrawals at up to 50%. You’re better off having the student’s parents own the account, which would give it much more favorable treatment in the Expected Family Contribution calculations. If grandparents wish to continue holding the 529, they often choose to wait until the last two years of the student’s higher-education period to minimize this effect.
Q: I live in South Carolina, one of a few states that permit joint 529-account ownership, and have established a 529 plan for my grandson. If my son and I were to jointly own the 529 plan, will Fafsa consider distributions as coming from the father (my son) or from me (the grandfather)?
A: This question isn’t answered in the rules. Check with the school’s financial-aid counselor, the state’s 529 program manager, or a Fafsa representative to see how this will work, Mr. Cox says.
“One reason most 529 plans limit account ownership to a single individual or entity is to avoid some of these tricky tax or domestic issues,” Ms. Morris says. However, in South Carolina specifically, joint 529 owners have to be spouses, so you wouldn’t be able to share ownership with your son, she says.
Q: If the beneficiary of a 529 is diagnosed with a mental or psychological disability that prevents them from using the money and there is no sibling or potential grandchildren to transfer it to, what are the rules on taking the money out and avoiding the 10% penalty?
A: IRS regulations state that such situations will be exempt from the penalty, but appear to give no guidance or IRS form on how to apply for such a waiver.
“Like you, we have not found any official guidance on this issue,” Ms. Morris says. One option may be to transfer at least some of the money, penalty- and tax-free, to an ABLE account. That is a tax-advantaged savings account offered in more than 40 states for individuals who developed certain disabilities, typically those that would qualify a person for Supplemental Security Income or Social Security Disability Insurance, before age 26. You can move up to $15,000 from a beneficiary’s 529 account into an ABLE account owned by the same beneficiary or someone in their family, with the amount you can contribute each year tied to the federal annual gift-tax exclusion limit, she says.
Q: When I die, who becomes the owner of the 529 accounts I own?
A: You can specify who owns your accounts after your death by designating a successor owner, Mr. Cox says. Contact your 529 plan to fill out the form.
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