The tax risks of overfunding your 529 college savings plan

Make sure you set aside the right amount to optimize savings and avoid unnecessary taxes and penalties

By Masood Vojdani

Jul 20, 2015 @ 12:01 am EST

Here's a typical scenario that happens in my world. A high-earning family walks in the door and wants to begin their retirement- and financial-planning process. The family is prepared, highly educated and committed to developing and sticking with a strategic plan. But here's what's also typical: the family has misconceptions about paying for college and the 529-plan-funding process.

Typically, a caring family member will say to me, “Masood, one of our absolute key goals is to fully fund our children/grandchildren's college education by maximizing a 529 plan.” This seems like a reasonable goal, and for many families that is the right choice.

But for others with the best of intentions, the story is different, and overfunding that 529 plan can be the wrong advice. Why? Because of the impact to financial aid and the penalties that can be incurred against unused funds.

(Related read: Money Milestones: Downsides of a 529 college savings plan)

Most 529 plans are similar in that they invest holdings in mutual funds and offer significant tax advantages as long as the money is used for qualified higher education expenses including tuition, books, room and board, and other supplies.

Parents and students have unknowingly negated this advantage by overestimating how much college will cost and contributing far more money than necessary.

Those utilizing 529 plans are often on stronger financial footing. A recent Government Accountability Office study found that the average household using 529 plans has a median financial asset value of $413,500, 25 times higher than the median asset value for families not using these accounts. But one's past financial success does not make one immune to the potential drawbacks.

I know of one situation in which a high-net-worth client was upset to find that money left over in a 529 plan (after his son finished college) was subject to both a 10% penalty and ordinary income taxes on earnings upon withdrawal.

A good tip to keep in mind for families who have more than one child is that they can avoid these penalties by rolling over excess funds into another beneficiary's 529 account. But single child families, such as the client noted above, may be left paying the taxes and penalties unless their child decides to attend graduate school or they have other family members they can transfer the funds to.

It is also worth keeping in mind that money earmarked for college in a 529 plan can count against a student's eligibility for need-based or merit-based financial aid.

(More: Top-Performing 529 Plans)

Merit-based financial aid can certainly be helpful even to those who are from high-income households. As of this writing, expenses average upwards of $40,000 a year for students that attend the average private four-year school and almost $19,000 for in-state residents to attend a public four-year institution, according to a recent study by The College Board. If a family has four children, for example, the expense of education can be steep. Needless to say, the figures I've cited will increase significantly in the years to come, adding pressure to families that have young children today.

To be clear, every family should consider having some 529 allocation. The critical question is: how much?

When used wisely, college savings accounts can benefit families, but the disadvantages should always be taken into consideration. It is important for families to consult with their financial advisers when planning for their children's and grandchildren's educations, and to set aside the right amount of money for these plans in order to optimize savings and avoid unnecessary taxes and penalties.

Masood Vojdani is founder and chief executive of MV Financial, a wealth management firm.

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