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How the New Tax Law Changed the 529 Plan Game Board

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The Tax Cuts and Jobs Act (TCJA) — the national tax reform legislation enacted in December — changed what advisors need to tell clients about the management of 529 plan college savings plans.

Internal Revenue Code Section 529 has given families a tax-advantaged vehicle for saving for future college costs.

If you regularly work in the area of education planning, you know all about the TCJA changes to the 529 plans. If you’re a life and health agent who simply gets an occasional question about how clients will pay for their children’s education, you need to know enough to hold your own when the topic comes up. You may also decide that the TCJA changes make this a good time to dive more deeply into education planning.

The TCJA changed the game board by providing increased flexibility for use of 529 plan funds.

(Related: Preparing for the Worst: Disaster Planning 101)

Families can now use 529 plan funds to pay for tuition for private elementary and secondary education, not just for college tuition.

From a financial planning perspective, that change shortens the “time horizon,” or the gap between the time when a client funds a 529 plan account and the time when the assets can be used.

That change has created the opportunity for life insurance advisors to offer clients more education planning services.

If parents of newborns choose to use 529 plan funds for elementary or secondary education tuition, they may need access to the funds four to five years after opening the accounts, compared with a time horizon of 18 years for funds that will be used to pay a newborn’s future college bills. This shift will affect clients’ investment strategies, as the portfolio may need to shift away from equity sooner.

As an advisor, you will need to decide whether to tell clients that they should allocate more money to 529 plans instead of to other savings accounts or personal protection arrangements. The advice will depend on a client’s age and other characteristics. However, in general, for clients who are even considering sending children to private elementary or secondary schools, investing more money in 529 plan accounts will provide more tax-free growth and higher returns.

The greatest advantage of the new TCJA 529 plan provision is greater flexibility for families. For instance, if a family moves a child to a private school it couldn’t otherwise afford, the family can use 529 funds to help shoulder the burden. Additionally, because 529 plans can be transferred between relatives, there will be a significant amount of flexibility for families with overfunded 529 plans.

The primary disadvantage lies in the fact that the new, shorter time horizon will create difficult discussions when it comes to investment strategy and allocation. As clients gain earlier access to the funds, they will likely wonder whether it’s necessary to have such a high allocation to equity in the accounts when children are young.

For those who choose to take advantage of the 529 plan program, it is essential that having a 529 plan works in their overall financial planning strategy. Clients should be careful not to pull cash from these accounts just because they can. As for those who do use the funds early, I would recommend taking tuition savings to fund another vehicle, to help ensure college savings are still in place.

A strategy advisors should consider is simultaneously funding a permanent life insurance policy, in order to leverage the increased value created under tax reform.

Funding both a 529 plan and a permanent policy designed for cash accumulation, as soon as a child is born, gives a family flexible options as it chooses where to enroll the child later in life.

If the child ends up enrolling in a private high school, the parents can use the 529 savings for that expense while continuing to fund the cash value of the life insurance policy.

If the 529 assets are depleted by high school tuition expenses, parents can then either use the cash value of the life insurance policy or take out a loan against the policy — whichever makes more sense at the time — to pay for college tuition.

Of course, if 529 assets are not depleted, the family should use 529 assets for college expenses before tapping the value of the life policy.  Any funds remaining in the life policy after college can be used for expenses unrelated to education, without penalty.

A major benefit of this strategy is the fact that the cash value from a permanent life insurance policy is excluded from the Free Application for Federal Student Aid when a student applying for financial aid in college, while 529 assets are included. Additionally, a permanent policy protects a child in the event the parents pass away—and can be used to cover college expenses. In this situation, use of a permanent policy can replace the common strategy of using term life insurance to cover college expenses in the event of the parents’ death.

The TCJA also presents options for grandparents who want to contribute to the college funds of their grandchildren. In many cases, grandparents can take advantage of the gift tax exclusion and accelerate five years of giving into one lump sum. The value of the tax-free growth from a lump sum is significant when compared with the growth from yearly contributions. For a couple that might be subject to the estate tax, this strategy also removes a significant amount of value—and therefore subsequent appreciation—from the estate without depleting the couple’s’ unified credit exemption.

— Read Debts After Death on ThinkAdvisor.

Jeffrey Phillips

Jeffrey Phillips, CFA, CPA, is a principal and managing director with Rehmann Financial based in the Vero Beach, Florida. The firm is an independent member of Nexis International. Securities are offered through Royal Alliance Associates, which is a member FINRA/SIPC. Investment advisory services are offered through Rehmann Financial, a registered investment advisor not affiliated with Royal Alliance Associates.