As parents get ready to send their children off to college, they are usually at the apex of careful financial planning that began in the nursery. While there are many ways to save for college, whether through a trust, IRA, or other investment tool, many people in California and elsewhere opt for a tax-advantaged 529 college savings plan.
California 529 plans, designed to help families save for college, are among the most popular educational savings tools available in the state. Named after Section 529 of the Internal Revenue Code, these tax-advantaged investment accounts allow Californians to grow their savings for qualified education expenses, potentially even beyond college.
While the benefits can be significant, California 529 plans also come with limitations and potential downsides, which families should consider as part of their overall financial and estate planning strategy. Here’s what you need to know about the primary benefits and potential drawbacks of using a California 529 plan to determine if it’s the right choice for your family.
What Is a California 529 Plan?
A 529 plan is a state-sponsored education savings plan that allows contributions to grow tax-free, provided the funds are used for qualifying education expenses. These expenses include tuition, room and board, books, and certain other costs associated with higher education. California’s 529 plan, called ScholarShare 529, offers a range of investment options. It is managed by a professional financial firm to help families increase their education savings over time.
What Are the Potential Benefits of a California 529 Plan?
Unlike some other states, California’s 529 plan does not offer a tax-deductible break on contributions. But it is still an excellent means of gifting as a revocable wealth transfer tool. Families can invest funds tax-free and then use them for qualified expenses, such as:
- Tuition
- Fees
- Books and supplies
Some other benefits of these plans include:
1. Tax-Advantaged Growth
Earnings in a 529 plan grow tax-free, and withdrawals are also tax-free if used for qualified education expenses. This can lead to substantial savings over the years.
2. Flexible Contributions
Unlike other tax-advantaged accounts, 529 plans have relatively high contribution limits. Contributions up to $529,000 are allowed per beneficiary in California, making it a suitable option for families who want to save more aggressively for education.
With a 529 plan, individuals can gift up to $15,000 per plan per year without a penalty, and this amount doubles for a couple. Or, they may give one contribution of up to $75,000 every five years or double this amount for a couple. The limit of a 529 plan in California is $529,000.
Additionally, California’s 529 plan accepts contributions from anyone, so parents, grandparents, other relatives, and friends can all contribute to a child’s future educational expenses.
3. Broad Range of Qualified Education Expenses
California 529 funds can be used not only for traditional college expenses but also for K-12 private school tuition, vocational school programs, and even certain international universities.
Recent legislation has allowed 529 funds to be used for student loan repayments (with certain limits) and some apprenticeship programs, which expands their utility for families with diverse educational goals.
4. Low Impact on Financial Aid Eligibility
A 529 plan owned by a parent is considered a parental asset on the Free Application for Federal Student Aid (FAFSA), which impacts a student’s eligibility for financial aid less significantly than assets in the student’s name.
Grandparent-owned 529s no longer impact financial aid calculations as of the FAFSA Simplification Act. Previously, distributions from these accounts counted as student income and could affect aid. However, that’s now changed, making grandparent 529s a more attractive option.
5. Investment Control and Estate Planning Advantages
Account owners have complete control over how the funds are used, including the ability to change beneficiaries to another qualifying family member if the original beneficiary decides not to attend college. Furthermore, contributions to a 529 are considered a completed gift for federal tax purposes, meaning that contributors can reduce their taxable estates while still maintaining control over the account.
What Are the Potential Disadvantages of a California 529 Plan?
Although 529 plans offer many wealth transfer benefits to parents, grandparents, and other family members who wish to minimize their own tax exposure, they do have limits that other estate planning tools do not. Because withdrawals that do not go toward approved education expenses will impose an automatic 10% federal tax on the earnings portion, plus a 2.5% state income tax, withdrawing more than needed could trigger a penalty.
Unless parents start a 529 plan early, it can be challenging to contribute enough within the remaining time frame. If market volatility creates losses close to high school graduation, there may not be time to recover before a child leaves for college. In addition, 529 plans often have limited investment options that may not provide the needed diversification.
Other possible drawbacks of California 529 plans include:
1. Limited Use of Funds
To maintain the tax-free advantage, withdrawals must be used for qualified education expenses. Non-qualified withdrawals incur income tax and a 10% penalty on the earnings portion, which can reduce the overall return on investment if the beneficiary does not need all of the funds for education.
Meanwhile, though recent changes allow for K-12 private school tuition and certain vocational programs, restrictions, and limits apply, which could impact families hoping to use a 529 plan for these expenses.
2. No State Tax Deduction for Contributions in California
California does not offer a state income tax deduction for contributions made to 529 plans. This can be a drawback compared to states that incentivize contributions with state tax benefits.
3. Market Risk and Potential Losses
California 529 plans are investment accounts, meaning the funds are subject to market risks. Families who choose more aggressive investment options may experience fluctuations and potential losses in the account value, especially in volatile markets.
The account holder’s risk tolerance and timeline for using the funds play crucial roles in determining the suitability of a 529 plan. Conservative families or those with shorter time horizons for college savings may prefer more stable options, such as high-yield savings accounts or prepaid tuition plans.
4. Fees and Expenses
While ScholarShare 529 has relatively low fees compared to some other investment accounts, all investment accounts come with some fees. Families should review these fees carefully, as they can affect returns over time.
Fees vary depending on the investment options chosen, with higher-risk options generally carrying higher fees. Comparing these costs against potential returns can help families make informed decisions.
5. Potential Impact on Estate Planning Strategies
While 529 contributions count as completed gifts for estate tax purposes, they are also irrevocable. Once a contribution is made, it belongs to the plan and cannot be taken back by the contributor, which may impact long-term estate plans. Additionally, the five-year gift tax averaging option allows larger contributions in a single year without triggering gift taxes. However, this locks in contributions over a set period, limiting flexibility.
When a California 529 Plan Might Not Be the Best Option
While 529 plans offer numerous benefits, there are scenarios in which they might not be ideal. Families with highly uncertain educational plans for their children or those who anticipate significant financial aid may find other savings vehicles more appropriate. In addition, families interested in more flexible use of funds for general expenses might consider custodial accounts or Coverdell Education Savings Accounts, which offer broader usage options.
Alternatives to California 529 Plans
Trust account plans are custodial trusts under state law that hold savings for a child with more flexible withdrawal options, as they are not limited to higher education expenses. While a custodian or trustee manages this type of trust, the funds will revert to the beneficiary at the legal age according to state law. The two basic types are Uniform Gift to Minors Act (UGMA) trusts, which mainly hold securities, and Uniform Transfer to Minors Act (UTMA) trusts, which may hold other assets. Other alternatives to these plans may include:
- Coverdell Education Savings Accounts: While contributions are limited to $2,000 annually per beneficiary, Coverdell accounts provide more flexibility in eligible expenses and can be used for additional non-educational costs.
- Roth IRAs: For families more focused on retirement, a Roth IRA allows contributions that can be used for qualified educational expenses without penalty, though they don’t offer the same level of tax-free growth for educational expenses.
San Jose residents can benefit from a comprehensive overview of possibilities that will be best suited to their unique circumstances.
How to Decide If a 529 Plan Is Right for You
Determining whether a California 529 plan is the right choice involves assessing both your financial situation and your educational goals. For families with a clear path toward higher education and a longer timeline, the tax-free growth potential and minimal impact on financial aid can make 529 plans highly advantageous. However, families with shorter timelines or the need for broader access to funds may find that a 529 plan’s restrictions limit its usefulness.
Talk to the Professionals About Whether a 529 Plan Is Right for Your Family
A California 529 plan can be an excellent tool for families looking to save for educational expenses in a tax-advantaged way. However, it’s not a one-size-fits-all solution. By weighing the pros and cons of 529 plans against other educational savings vehicles and personal financial goals, families can make informed choices about whether a 529 plan aligns with their needs.
For those looking to integrate a 529 plan into a broader estate and financial planning strategy, The Dayton Law Firm P.C., is here to help. We can guide families through the complexities of education savings, estate planning, and tax considerations, ensuring that your legacy aligns with your goals for both education and financial security.
