Pros and Cons of 529 Plans

So you want to start saving money for college? With the cost of higher education doubling in the last 30 years, starting to save early is a great idea. Whether it’s for your own kids, grandkids, nieces/nephews, or maybe even your God children, helping a child you love cover at least some of the expenses associated with higher education is an amazing gift. A great option for starting to build an education-specific savings account is a 529 plan. These incredibly popular plans also offer a few tax benefits.

529 plans first came onto the scene in the mid-1980s and originally functioned as a pre-paid tuition account. By the 1990’s, Section 529 (hence the name 529 plan) was added to the Internal Revenue Code, allowing for a tax-free status for certain tuition programs. These accounts grow on a tax-deferred basis (meaning tax isn’t owed on the earnings) and if the recipient makes withdrawals from the account for higher education expenses the withdrawals are not taxed either.

Every state has at least one 529 plan available. However, you do not have to invest in a plan in your state or even the resident state of the intended recipient. Additionally, for most plans, the choice of college is not affected by the state that sponsored the plan. Currently more than 6,000 U.S. colleges and universities and 400 foreign colleges and universities will allow students to utilize a 529 plan for tuition and other education expenses.

What expenses are approved?
Tuition, room and board, and textbooks were the original expenses included in the plans approved costs. In recent years, the original definition of “higher education expenses” has been expanded to reflect the changing landscape and increasing costs of education. These expenses can now include computers, up to $10,000 annually in k-12 tuition, student loan payments, and even the costs of apprenticeship programs.

What are the tax benefits?
From a federal tax perspective, 529 plans offer significant benefit in terms of tax-free growth and tax-free withdrawals. 529 plans can be invested in many ways, such as guaranteed returns and even mutual funds or stock market investments. In a typical investment account, any growth would be considered taxable income. With 529 plans, the accounts can see significant growth and if the withdrawals are made for approved, educational purposes, no tax will be paid on that growth.

State-specific tax benefits generally are enhanced or dependent on the plan being an in-state plan (i.e. the state in which the contributor resides and pays income tax). There are a few exceptions to this: Arizona, Kansas, Maine, Missouri, Montana, and Pennsylvania are referred to as tax-parity states and offer income tax benefits regardless of the state plan utilized.

How much money can I invest in a 529 Plan?
With the gift tax exemption amount (2020) of $15,000, 529 accounts can be funded in large amounts. This means that a married couple can contribute up to $30,000 ($15,000 per contributor) per child each year without having to file gift tax returns. Better yet, for grandparents with the desire to make a large contribution, a 5 year election rule is in place. This means that grandparents can elect to contribute 5 years’ worth of the gift tax exemption at one time, totaling a contribution of $75,000 all at once. While a gift tax return would have to be filed, the use of the 5 year election has no impact to the overall estate exemption.

Unfortunately, there are some funding limitations that do exist. Generally, 529 plans cannot have amounts greater than $235,000 in the plan. However, if the plan does cross that threshold, only contributions need to be suspended.

What if my child doesn’t go to college?
In some cases, children opt out of college education or receive scholarships and grants that cover college expenses. In this case, there will unfortunately be a tax bill to be paid if funds are distributed for a non-qualifying expense. Taxes on distributions of that manner include income taxes on the earnings, as well as a 10% withdrawal penalty. To top it off, many states require the tax benefit to be repaid for funds distributed in this manner.

For families with multiple children or qualifying relatives, there could be a much better way. 529 plans allow owners to add beneficiaries even after the account has been funded. By adding a beneficiary, owners can avoid taking taxable withdrawals as well as provide funds to another child or beneficiary. Adding a beneficiary does not cause a taxable event, so no taxes will be due because of the additional beneficiary either.

Questions about 529 plans or other tax planning strategies? Get in touch with our office!

Co-Signing on a Mortgage? Here’s What it Means for Your Taxes

It’s not uncommon for parents or grandparents to call us about the possible impact on their personal taxes should they co-sign a mortgage with a child/grandchild.  This has become increasingly common in 2020 with plummeting interest rates.  It’s important to understand the obligations that come from agreeing to this as well as the possible negative impact on the cosigner.

Typically, someone is asked to cosign a mortgage for credit reasons; the individual looking to purchase a home has the financial means to do so but lacks the credit history for loan approval.  The higher credit score and additional income created by adding a cosigner makes a loan more appealing to lenders and their underwriters.

When it comes to cosigners, mortgage companies are looking for a few key factors: low debt-to-income ratio, stable income, and a good credit score.  An approved cosigner would appear on the mortgage application and other loan documents, but not typically on the property itself.  In other words, the cosigner does not generally have rights to the property.  They do, however, have an obligation to ensure that payments are made timely. This means that if the primary mortgage holder fails to make payments, the bank will look to the cosigner.

There are a few concerns that a cosigner should keep in mind before signing on the dotted line.  First, there is a risk to the cosigner’s credit score.  If payments go unmade, this will negatively impact the cosigner’s credit in addition to the primary mortgage holder’s.  Next, the cosigner’s debt to income (DTI) ratio is affected.  Even though the cosigner is unlikely to be responsible for making the mortgage payments, on paper the mortgage will appear as a liability for the cosigner.  Should the cosigner find him or herself in need of a loan, lenders will see the DTI as less attractive.  There is also the risk of creating a tense situation amongst family members.  If you decide to cosign for someone, we highly recommend that you have a very frank, business conversation about the realities of this agreement and possible outcomes.

What about taxes?

In short, you can cosign a mortgage without creating any impact on your personal taxes, though there is a risk to your credit and personal expenses.  However, for tax treatment, if your child takes sole responsibility for the home and expenses and your name is only on the mortgage as a formality, he/she can claim all the tax deductions from mortgage interest and property taxes paid.  Additionally, when the property is sold, all the proceeds from the sale can be solely on his/her return, thereby creating zero tax impact for the cosigner (so long as the seller maintained the property as a primary residence).

Alternatives to cosigning

Do you still want to help your child or grandchild purchase a home but find yourself unwilling to take on the risk of cosigning a mortgage?  There are a few alternatives:

Hold the mortgage yourself.  Some potential cosigners have the financial means to purchase the home themselves.  They could then rent the home to their child or owner finance the property until the child has the financial means to purchase it from the parents.

Down payment or closing cost assistance.  Sometimes a less than ideal credit situation for the purchaser can be remedied by increasing the closing costs contribution or down payment.  Often, however, the purchaser lacks the additional cash to do this.  Instead of cosigning, a parent could gift the additional funds to the child.  Remember that some gifts may create a need for a Gift Tax Return.  Alternatively, the parent could loan the child the additional funds.  Be sure to check with your financial advisor or CPA for specific rules and regulations regarding family loans.

Legal Considerations

There are important legal factors that should be considered before entering into this type of agreement.  What happens if one party passes away?  Who inherits the property?  Can the deceased’s estate be targeted by the mortgage holder?  What about different types of ownership?  Does one make more sense than the others?  Consult with your CPA, attorney or real estate professional to discuss how you could be affected.

Love Letter from the IRS? Don’t Panic!

Are you one of the lucky tens of thousands of American taxpayers who received a letter in error from the IRS?  If so, don’t panic!  According to Richard Neal (House Ways and Means Committee chairman, D-Mass), there were roughly 12 million pieces of unopened mail in IRS offices across the country.  This was the result of many IRS workers working from home during the pandemic.  In those enormous piles of mail are paper tax returns, correspondence, and (you guessed it!) tax payments.

The IRS has started sending out letters to address unpaid balances.  The problem is that many of those tax payments were mailed, they just remain unopened.  As taxpayers receive these letters, they panic.  However, there is no need to panic!  If you mailed a check to the IRS the first thing you should do is check your bank account.  Has the payment cleared?  If not, then there is nothing for you to do but wait.  Clarification letters are being sent out as payments are processed.  If your check has cleared and you still received the letter, we recommend calling the IRS to discuss the payment with a representative.  It may be a clerical error or the letter may have been sent before the payment was processed.

Have you received a letter from the GA Department of Revenue or another state’s taxing authority?  The first step is to call and request an explanation of the penalty.  There are two likely causes:

  1. Your payment was received after the typical April 15th deadline but before the July 15th deadline.  If the state’s system was not updated to recognize the new filing deadline this year, you may have been assessed a penalty even though your payment was not late.
  2. You had a sizeable balance due and are being penalized for failure to make estimated payments.

Why would you be penalized for not making estimated payments?  Remember that our tax system is a pay-as-you go system meaning tax is due when it is earned.  This is why W-2 employees have taxes withheld from each paycheck.  If your balance due at filing is greater than $1,000, both the IRS and state taxing authorities reserve the right to calculate a penalty for failure to make estimated payments.  For more information on estimated payments, check out our previous blog post.

Were you owed a refund that you have not yet received?  The IRS has announced that it will pay refund interest on any return filed before the July 15th deadline and that interest will be calculated from April 15th.