If a nonqualified distribution is made, penalties generally outweigh benefit of tax deferral.
College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to email@example.com.
I have often said that one should be careful not to "overfund" a 529 savings account, because if a nonqualified distribution is made, generally the income tax and penalty on the earnings will outweigh the benefit of the income tax deferral. This is especially true where the excess assets, if they had been invested outside a 529 fund, would have been wholly or partially invested in equities, because dividends and capital gains outside of a 529 savings account are subject to favorable tax rates. In contrast, the earnings portion of an equity investment inside a 529 savings account will be taxed at ordinary income tax rates when a nonqualified withdrawal is made.
I have also often advised that once a 529 savings account is "fully funded," the donor should make any additional gifts to a different vehicle for the beneficiary, such as a trust.
But how does one determine when a 529 savings account is fully funded for a particular beneficiary? When funding an account for a minor, one doesn't even know with certainty whether the beneficiary will pursue education beyond high school. Other unknown variables include the ones below. Of course, a donor can only make educated guesses about these variables, hopefully with increasing certainty as the beneficiary grows and matriculation approaches.
An overfunded 529 savings account is an account that, using one's best guesses about the above variables, will have funds left over when the beneficiary completes his or her higher education. A 529 savings account is fully funded when it has a value that, based on the assumed variables, will be just sufficient to fund the beneficiary's higher education expenses.
There are many college-cost calculators available on the Internet. However, those who are do-it-yourselfers, or who believe that the ready-made calculators do not take into account all of the relevant variables, may find the following "decision tree" helpful.
Caution: You must read the footnotes to the decision tree to understand it. The footnotes contain important statistics from two CollegeBoard publications, Trends in College Pricing 2006 and Trends in Student Aid 2006. These publications may be accessed at www.collegeboard.com/trends. The references in the footnotes to specific Figures and Tables are to the complete publications. College Board also has available PowerPoint slides, which contain some of the same information shown in the Figures and Tables in the full reports. Several of these PowerPoint slides are here for your convenience and are referred to as Exhibits.
Generally, in determining what would be a fully funded 529 savings account for a single beneficiary, I would advise a client to estimate conservatively. Assuming the client is willing to make any additional gifts to a trust once the 529 savings account is fully funded, if higher education expenses exceed the assets in the 529 savings accounts, the trust assets can be used for the excess expenses.