What are the key product feature differences between 529 plans and Education Savings Bonds for college financial planning?
This week, we will compare and contrast 529s and Education Savings Bonds for college financial planning.
The Old Meets Competition from the New Investment Vehicle Used for College Financial Planning: 529s and Education Savings Bonds. Both 529s and Education Savings Bonds allow families to save money for education with tax exempt asset growth. This week, we discuss those types of savings bonds that are considered Education Savings Bonds, as they have a have a special tax provision for higher education that allow for tax deferred growth and tax-free distributions when used for qualifying expenses. Otherwise, interest must be reported in the year earned, or when cashed out. In order to qualify as an Education Savings Bond, the bond must be a series EE bond issued after 1989 or be a series I bond in the name of a U.S. citizen or resident alien at least 24 year old when the bond is issued. While there are many different types of savings bonds, we will focus on those with a special provision for higher education. Therefore, this article will focus on comparing 529s to Education Savings Bonds. For simplicity, this article will stay centered on using the vehicles to pay for higher education, as opposed to the merits of using savings bonds as an emergency fund or for other goals outside of college financial planning. That being said, the next section on market sizing notes the high volume of assets earmarked in cash and banking products for college financial planning, given the value of liquidity in the current marketplace despite the low return on investment. Therefore you as an advisor can provide value by knowing these differences in investment vehicles, selecting the right investment vehicles based on the unique needs of your clients, and creating a holistic financial plan that is customized to the unique needs of your client.
Market Sizing: As of December 2015, 529s allowed 12.7 million families to save over $253 billion in assets based on data by Strategic Insight. Of that, 11.6 million families saved over $230 billion in 529 savings plans while 1.1 million saved over $23 billion in 529 prepaid accounts. In addition to the $253 billion in 529s, families have saved approximately $274 billion in cash and other banking products such as savings bonds for college financial planning as of December 2015. Savings bonds are included as a percentage of the $274 billion in cash and other bank products as of December 2015, compared to $321 billion as of December 2014. This decrease is due to both the low interest rates offered by banks in the current market environment, as well as the decrease in demand for savings bonds once EE Bonds were not physically issued any more since 2011. Despite EE Bonds only being available electronically going forward, physical paper I Bonds can still be purchased with your IRS tax refund at face value. Also from a historical perspective, 529s started 20 years ago and have provided a viable alternative to savings bonds since then. Therefore while assets in 529s continue to rise on a year-over-year basis, assets in savings bonds for college financial planning continues to decrease.
Compare and Contrast:
— Income Limit: 529 plans do not have an income limit. While there is not an income limit that would prevent someone from purchasing an Education Savings Bonds, the income tax exemption phases-out from $77,200-$92,200 for individual tax filers, and $115,750-$145,750 for joint filers as of 2016. If the owner of the Education Savings Bond is married, then a joint tax filing must be used in order to receive the special tax treatment. Also, the income limits are as of distributions are made, and so the owner of an Education Savings Bond may purchase the bond when they would receive tax exempt distributions, and may need to pay taxes when distribution are made due to an increase in the owner’s income. Also, Education Savings Bonds require that the owner’s modified adjusted gross income (MAGI) be less than the amount specified in one’s filing status, which adjusts for several deductions such as student loan interest, tuition and fees and foreign income. Therefore 529s do not have income limits, while Education Savings Bonds do have income restrictions in place
—Age Restrictions: While there are not any age restrictions on 529 college savings accounts, accountowners must be at least 24 years old when the bond is issued to qualify as an Education Savings Bond
—Contribution Limits: 529s allow investors to contribute up to the annual gift taxing limit of $14,000 per year per account-owner beneficiary relationship, or $28,000 per joint filing married couple as of 2016. Additionally, 529s allow an accountowner to make five years of gifting in one year such as $70,000 per single filer or $140,000 per joint filing married couple. Lastly, 529s allow a sizable maximum account size that aligns with the cost necessary to provide for the qualified education in a state, and is typically more than $300,000. For Education Savings Bonds, owners can purchase a total of $10,000 per year per person for Series I and EE bonds as set by the U.S. Treasury, and are not subject to gift tax treatment or maximum account sizes. Lastly, assets in 529s are removed from the taxable estate, while assets in Education Savings Bonds remain in the estate.
—Tax Benefits on Contributions: Though there is not a federal tax deduction for contributions into 529s, residents in over 30 states plus D.C. receive a state tax deduction or credit for contributions into a 529 plan. Education Savings Bonds provide state and federal tax deferred growth and tax-exempt distributions when used for qualified higher education expenses.
—Market Risk: 529 college savings plans allow parents to self-direct their investments among a menu of options, and therefore adjust their level of risk. Education Savings Bonds are backed by the U.S. Government, though they provide a comparatively low interest rate of return. While I bonds are meant to keep pace with CPI which is less than tuition inflation, EE bonds provide a variable interest rate.
—Investment Changes: 529s are granted two investment changes per year. Education Savings Bonds allow distributions to be paid for qualified higher education expenses, or to be transferred tax-free to 529s or Coverdell Education Savings Accounts
—Account Control: 529s allow the accountowner to maintain control of the account, and allow for an unlimited number of rollovers if the beneficiary is changed to a member of the family of the previous beneficiary. Therefore, 529s allow changes in beneficiaries while the accountowner maintains control of the account. Education Savings Bonds also allow the accountowner to maintain control of the account, though the qualified higher education expenses must be used for the accountowner, spouse or dependent that the accountowner receives a tax exemption for. Therefore, 529s provide account control, and greater flexibility on who the funds are used for
—Financial Aid: 529 assets increase expected family contribution (EFC) by 5.64%, but distributions from 529s do not impact EFC. As the owner of Education Savings Bonds must be at least 24 years old at time of purchase, they are the asset of the parent and therefore increase EFC up to 5.64% as an asset and increase EFC up to 47% as income when distributions are made.
—Qualified Expenses at Eligible Institutions: Education Savings Bonds include tuition and fees such as lab fees or other required course expenses as qualified expenses at the same list of schools as 529s, and exclude books, room and board, or courses on sports or hobbies from non-degree granting programs. 529 savings plan assets can all be used for any qualified higher education expense such as tuition and fees, supplies and computer technology for the vast majority of colleges and universities in the U.S. and many abroad so long as they are eligible for financial aid from the U.S. Government. As with 529s, Education Savings Bonds must have the distribution in the same year as the qualified higher education expense was occurred. Non-qualified distributions from 529s can be made, though the earnings portion will be subject to tax and a 10% penalty. There are a list of exemptions to this 10% penalty, as covered in a prior 529 Insider “529 Essentials” column. Non-qualified distributions from Education Savings Bonds are not subject to a 10% penalty, though earnings would incur federal tax.
—Distribution Restrictions: 529s allow distributions to the school, accountowner or beneficiary. Education Savings Bonds allow distributions to be paid for qualified expenses, or to be transferred tax-free to 529s or Coverdells Education Savings Accounts.
Therefore, advisors, accountants and estate planners should understand the key product features of 529s and Education Savings Bonds to ensure the most appropriate investment vehicle is used for college and holistic financial planning based on the specific goals of your clients.
Next week, we will compare and contrast 529 savings plans and insurance products for college financial planning.