Yellowstone Financial, Inc.

Changes Afoot For College Savings Plans

With the passage of the new federal tax law in the waning days of 2017, college savings plans have a new purpose.  The new tax law made distributions of $10,000 annually from 529 college plans tax and penalty free to pay for elementary and secondary school tuition expenses, with some caveats that aren’t well publicized.  If that doesn’t rock your college saving world enough, Colorado’s low-cost CollegeInvest Direct Portfolio plan will make meaningful changes to its automated investment strategy later this week.

Before we dive into the details, let’s talk about the purpose of 529 college savings plans.  Introduced over two decades ago, 529 plans are much like Roth IRAs for higher education tuition, room, and board expenses.  You deposit after-tax dollars that are then invested in what are essentially stock and bond mutual funds.  You name a future or current student as beneficiary when you open the account.

Once the beneficiary enrolls in post-secondary school, you can direct the college plan to pay the institution directly or reimburse you soon after you pay the bill.  Room and board costs can also be reimbursed as long as the student is enrolled at least half-time.  Qualified distributions of 529 funds are not subject to income tax, even if the account has grown since you funded it.

Colorado adds an unparalleled boost to this tax savings bonanza.  It allows Colorado residents to deduct from state income tax 529 account deposits.  Say as a Colorado resident you deposit $5,000 for both of your two children in a Colorado 529 account.  You can reduce your Colorado taxable income by $10,000, thus saving you over $400 in taxes.

This deal has grown even sweeter with the availability of accounts managed by low-cost behemoth Vanguard marketed as the Direct Portfolio plan.  Colorado residents thus doubly benefit from among the lowest costs, and a practically unlimited state income tax deduction that exists in only a few states.

It is this exceedingly generous tax break that is giving some state lawmakers pause when considering the use of 529 plans for elementary and secondary education, which was just made possible with the new federal tax law.  There is consistent bipartisan support for subsidizing higher education costs, but less agreement on whether the same tax break should be extended to elementary and secondary school.

Currently those in Colorado who take 529 plan distributions for pre-college tuition up to $10,000 per beneficiary find themselves in tax limbo.  The gains on those distributions would not be taxable or penalized at a federal level, but most likely the entire distribution would be subject to Colorado’s 4.63 percent state income tax.  The state legislature is considering two opposing bills that address pre-college distributions.  Until a bill is passed, don’t count on taking Colorado tax-free distribution for pre-college expenses.

Now for the other change in Colorado 529 plans.  The Direct Portfolio plan later this week is modifying its popular and convenient age-based portfolios, which automatically change the investments to be more conservative as the beneficiary child gets older.  The new age-based options will come in three flavors just as before: conservative option, moderate option, and aggressive option.  But the new versions of all three flavors will be invested more in stocks than before.  Plus as the student beneficiary gets older, the plans will more gradually shift to be more conservative.

As an illustration, currently an account held for a 12 year old in the aggressive age-based option is invested 50 percent in stocks.  Effective March 23rd, that same account will be invested 62.5 percent in stocks until the child’s 13th birthday.  Personally, I like the changes in the age-based plans, but they may not be a good fit for those who monitor account balances with regularity and fear a big decline in the markets.  Colorado college savers should consult to see if the new allocations are still in line with their ability to tolerate the increased risk.  If they aren’t, you may want to pick a more conservative age-based option.

Finally, those with moderate or low incomes may be eligible for a $400 grant for five years if they apply to the CollegeInvest matching program.  If you are a family of four with an adjusted gross income of $73,800 or less, you may qualify for a matching 529 contribution for your child.  Make a reminder on your calendar as applications will be accepted starting this Fall.