The 529 college savings account is among the most effective savings vehicles available in the tax code, according to Erin Wood, senior vice president of advanced planning at AssetMark. That said, the accounts do present some important distinctions that financial advisors and their clients must keep in mind.
Wood spoke with ThinkAdvisor about the accounts in advance of 529 Day, marked each year on May 29. It’s a date increasingly recognized by financial planners and 529 account service providers, according to Wood, especially as the cost of a college education continues to grow.
“This is a really interesting moment for 529 accounts,” Wood said. “We’ve reached the point where many people who jumped on the accounts when they were first created in the late 1990s have been able to superfund them, while others are now growing more interested in starting 529 accounts thanks to added flexibility provided for by more recent law changes.”
Those changes, according to Wood, include the newly created ability to roll unneeded 529 account assets into a Roth individual retirement account. She’s also interested to see whether a current proposal to allow 529 funds to be used to pay for professional certifications — like the CFP credential or continuing education credits — will become law.
“It’s important to have that flexibility, because the first question that clients tend to ask about starting a 529 account is about what will happen if their child or beneficiary doesn’t end up going to college or doesn’t end up needing the money,” Wood said. “We now have some good answers to that question that give people more confidence that funding a 529 account is the right way to go.”
Wood said she expects 529 accounts to grow in popularity as the public’s understanding of their funding and use improves. To that end, she shared a number of tips to maximize the utility of 529 accounts.
Pro Tip No. 1: Understand Beneficiary Change Options
Generally speaking, a 529 plan account owner may change the beneficiary at any time without tax consequences, Wood observed, when the new beneficiary is a family member of the current beneficiary. The Internal Revenue Service provides a broad definition of an eligible family member, which includes the original beneficiary’s blood relatives and relatives by marriage and adoption.
“Before changing your 529 plan beneficiary, however, it’s important to understand who qualifies as a member of the beneficiary’s family,” Wood said.
According to the IRS, a member of a 529 plan beneficiary’s family includes the beneficiary’s spouse; a son, daughter, stepchild, foster child, adopted child or descendant; a son-in-law or daughter-in-law; a sibling or step-sibling; a brother-in-law or sister-in-law; a father-in-law or mother-in-law; a father or mother or ancestor of either stepmother or stepfather; an aunt, uncle or their spouse; a niece, nephew or their spouse; or a first cousin or their spouse.
That’s a pretty comprehensive list, Wood said, but it doesn’t necessarily cover everyone a person might want to name as a beneficiary. Other choices come along with irreversible changes in the future potential renaming of beneficiaries.
“For example, I’ve heard of godparents wanting to name their godchildren as beneficiaries of a 529 account,” Wood said. “If they were to do that, then any future changes in the beneficiary could only be made within that godchild’s bloodline. So, it’s important to understand what happens when you do change the beneficiary.”
Pro Tip No. 2: Mind the Investments
Clients who start 529 accounts when their children or beneficiary are young tend to use investments that mirror target-date funds that are popular within 401(k) plans, Wood said.
“A lot of people are using automatically rebalanced age-based funds within their 529 accounts, with the thinking being similar to what we see in retirement accounts that ramp down risk as the expected distribution date approaches,” Wood said. “That’s an effective strategy for 529 accounts, but we need to remember that changes in the beneficiary can change the distribution time horizon very significantly.”
Frequently, a saver who isn’t getting good advice will forget to address the asset allocation of a 529 account upon switching the beneficiary.
“That might not be a big deal if there isn’t a big age difference between the beneficiaries, but if there is, it can really throw the account out of balance with its intended use,” Wood said. “The funds in the account might lose out on years of growth, on the one hand, or they could be exposed to significant market losses right when they are needed.”
Pro Tip No. 3: Consider Accelerated Gifting
As Wood noted, a provision of 529 plans allows a contributor to elect to aggregate up to five years of contributions through a concept known as “accelerated gifting.”
The strategy has two primary benefits: helping the gift-giver reduce the size of their taxable estate and allowing more funds to be invested earlier within the 529 account. Notably, accelerated gifting exhausts the donor’s annual gift tax exclusion to that beneficiary for five calendar years, so no further gifts can be made until that time has passed if the maximum gifts are given.
Pro Tip No. 4: Account Owner Changes Have Risks
One risk of superfunding 529 accounts with more money than is likely to be needed by any anticipated beneficiaries, according to Wood, is that the original owner will at some point die and pass on ownership of the account.
“It’s possible for the new owner to be a trust, but that comes along with a lot of nuances and legal issues to consider, so we don’t see that happen in practice very often,” Wood said. “More often, a new account owner is an heir, spouse, etc. I always caution people by warning them that, that once you are no longer the owner, the new owner can simply cash it out and pay the taxes and penalties.”
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