Saving for College with a 529 Plan

What's the best way to save for college? There's no single answer that's right for everyone. But, plenty of people are overlooking the opportunity to enjoy tax savings while stashing away dollars for a qualified tuition plan, also known as a 529 plan.

Taxpayers have been reluctant to pursue this investment plan because of common misconceptions. In this column, we will provide some basic information regarding this education savings plan and hopefully generate your interest in saving for the future of your beneficiary.

Update:  August, 2006 - Revised kiddie tax affects college savings plans.

The TIPRA change of "under age 14" to "under age 18" for the kiddie tax, affects educational funding.  Certain tax-favored educational funding provisions, such as the 529 plan, have become even more attractive as a result of the statutory changes in the kiddie tax.

Update:  August, 2006 - Pension Protection Act

The Pension Protection Act will give permanent tax-exempt status to 529 college savings plans properly used. The favorable tax treatment was scheduled to expire on December 31, 2010 when it would have returned to what it was before 2002. Prior to 2002, 529 plan earnings grew tax-deferred and when the money was withdrawn it was taxed at a child's rate. Keep in mind that the Pension Protection Act did not change the treatment of Coverdell Education Accounts.

What is a 529 plan?

It is an investment plan operated by a state designed to help families save for future college expenses with tax advantages. To date, all 50 states and the District of Columbia have 529 Plans.

What are the advantages of contributing to a 529 plan?

A tax break. Your investment grows tax-free as long as the money stays in the plan. Distributions, including cash and earnings, may be excluded from the beneficiary's gross income to the extent that the distribution is used to pay the Qualified Higher Education Expenses (QHEE's) of the beneficiary. A 10 percent penalty will apply to any distribution that is not used to pay QHEE's. Individual states may offer other incentives, such as an upfront deduction for contributions, or an exemption from income on withdrawals. For example, Iowa 's upfront deduction for 2005 is up to $2375 per year, per beneficiary, while Nebraska 's is up to $1000 per return, per year.

Control. The donor maintains control of the account, so the beneficiary can't get at the funds. That's a big advantage over the better-known custodial accounts set up under the Uniform Transfers to Minors Act (UTMA), where the child has the final say once he or she reaches the age of majority.

Eligibility. Everyone can use a 529 plan. There are no AGI limitations on the contributor or the beneficiary. Also, large contributions are permitted. Rhode Island , for instance, leads all states allowing contributions until the beneficiary's account balance reaches $315,270. And there is often no residency requirement, so you can even set up plans in more than one state

Easy and Simple. Once you decide which 529 plan to use, complete a simple enrollment form and make your contribution (or sign up for automatic deposits). Then you can relax and forget about it if you like. The ongoing investment of your account is handled by the plan.

What are the disadvantages of the 529 plan?

People who like to take control of their investments are likely to be disappointed due to the restrictions to direct the investment of their accounts. Effective Sept. 7, 2001, the IRS announced a new policy that permits 529 plan participants the opportunity to change their investment strategy once every year.

The money must be used for education expenses, or the government will assess a 10 percent penalty on the earnings portion of the withdrawals.

Prepaid tuition plans, which fall under the umbrella of section 529 may also affect eligibility for financial aid.

What are ‘qualified higher education expenses'?

Currently, these expenses are tuition, fees, and the costs of books, supplies and equipment required for the enrollment or attendance of a beneficiary at an eligible education institution (accredited post-secondary educational institution offering credit towards a bachelor's degree, an associate's degree, a graduate level or professional degree, or another recognized post-secondary credential institution). Also, the amount for room and board of the beneficiary is included, if incurred while attending an eligible education institution if the student (beneficiary) is at least a half-time student in a degree program.

Who can contribute to a 529 plan?

A 529 plan may be established without regard to age, income level or residency of the Taxpayer or Designated Beneficiary.

Who can be named the designated beneficiary of a 529 plan?

Currently, family members can be named as beneficiaries of a 529 plan. Family members include father or mother, or an ancestor of either; son or daughter, or a descendant of either; stepfather or stepmother; stepson or stepdaughter; brother or sister, stepbrother or stepsister; bother or sister of the father or mother; brother-in-law, sister-in-law, son-in-law, daughter-in-law, father-in-law or mother-in-law, son or daughter of a brother or sister; or spouse of the designated beneficiary. First cousins were added to this list as part of EGTRRA of 2001.

What is the minimum and maximum amount I can invest in a 529 plan?

Federal law has indicated the gift tax exclusions and exemptions effectively serve as the limit to a 529 plan. The federal law has no income limit applicable to the donor when contributing to a 529 plan. (529 plan has no income phase-out.) The federal law also has no boundaries for minimum and maximum investment amounts. Each state has set up their requirements for these amounts.

What is the penalty for non-qualified withdrawal of funds in my 529 plan?

Federal law requires the 529 plan charge a penalty if a withdrawal is not used to pay for qualified higher education expenses. Based on this guideline, most states are collecting a penalty of 10% of the earnings portion of a non-qualified withdrawal, in addition to federal income tax. You can change the beneficiary at any time in order to keep the account going and avoid (or delay) taking non-qualified withdrawals when the original beneficiary doesn't need those funds.

What are the age or time limitations of a 529 plan?

There is no age or time limitations imposed by federal tax law. However, some states have setup limitations and guidelines in one or both of these areas. Check the state plan before enrolling.

What investment considerations do I have with a 529 plan?

There are numerous different investment programs available for residents of a state to participate in, each sponsored by the state and managed by a reputable bank, mutual fund or investment management company. Each state has it's own allocation of funds profile. We suggest that you carefully review the state (or states) program prior to enrolling. You can explore the basic plan details by state, on the website, www.savingforcollege.com .

Can I invest for one beneficiary in more than one state's 529 plan?

Yes. There are a several states that have 529 plans without any state residency requirements. Both Iowa and Nebraska are fully open to nonresidents. You can open accounts in as many of these states as you like, although in most cases there is little reason to have accounts in more than two or three states.

Can I transfer my existing Education IRAs into a 529 plan?

Yes, you can accomplish these rollovers without triggering tax, but you must be careful about ownership issues. The Education IRA is owned by the beneficiary, and so it may not be proper to transfer funds into a 529 account that is owned by you. Check the individual state 529 plan for clarification.

Can I contribute the maximum amounts in more than one state?

Currently, the IRS does not require that states applying contribution limits count your investment in other state 529 plans. Of course, the account owner will pay the penalties and income tax if the contributions exceed the amount of the designated beneficiary's qualified higher education expense with no other beneficiary to name for the remaining balance. And, if a state determines that you have made contributions without the intent to use the account for college, it will terminate your account and perhaps assess an extra penalty. Non-resident state 529 plan participants should consult a qualified tax adviser to determine their resident state tax consequences of their participation in the non-resident 529 plan.

Which state has the best 529 plan?

That decision must be based on your own circumstances and objectives. Programs can vary widely from state to state, so it's important to examine the rules and investment options of each. The better ones offer state tax deduction for contributions, state tax exemption for earnings used for college, exclusion of 529 plan from consideration in state-funded financial aid programs, and extra perks such as matching grants. On the investment side, look for plans that have well designed investment strategies and highly rated investment products. Suggested state plans to review are Nebraska , Utah , Virginia , New York , Alaska or Wisconsin .

What is the best place to put college money for children; 529 plan, Education IRA or UGMA (Uniform Gifts to Minors Act) account?

The type of plan you choose should be based on your income, how old your child is and whether you expect any financial aid. Following are some comparisons:

Maximum Contribution

529 Plan – Around $100,000 to $300,000, depending on which state's plan you choose.

Education IRAs – For 2005, $2000 per year per beneficiary.

UGMA – Unlimited. (But, watch the ‘Kiddie Tax' for children under age 14.)

Investments

529 Plan – Many states offer only three or four investment options. Once money is invested, it is difficult to move.

Education IRAs – You decide where to establish the account and which stocks, bonds or mutual funds to invest in.

UGMA - You decide where to establish the account and which stocks, bonds or mutual funds to invest in.

Financial Aid

529 Plan – Assets are considered the parents', which helps with financial aid qualification. Though withdrawals will be federal tax free, the income is considered the child's, which hurts those seeking aid.

Education IRAs – The assets and income are considered the child's, which is harmful for those trying to qualify for financial aid.

UGMA – Assets belong to the child, which is harmful when qualifying for financial aid. Also, the child can take them and buy a car instead of using for their college.

Taxes

529 Plan – Investments are tax-deferred. Earnings withdrawn in 2001 incurred federal tax. Starting in 2002, earnings became free of federal income taxes if used to pay qualified education expenses such as tuition, books, and room and board.

Education IRAs – Investments are tax-deferred and withdrawals are tax free for qualified educational expenses, which not only include college expenses but private elementary and secondary schools, tutoring or a computer.

UGMA – Investments are taxable, but are assessed at the child's tax rate at age 14 and on.  Before age 14 they are assessed at the parent's tax rate.

What is the consequence of moving money from a child custodial account into a 529 plan?

Most 529 plans allow such a transfer, but there are a few special rules. Money you put into the child custodial account was an irrevocable gift, and moving it to a 529 plan doesn't change that fact. For example, the money can never be shifted to another beneficiary and your child will control it when reaching the age of majority, either 18 or 21, depending on state law. New money put into a separate account in the same 529 plan can still be controlled by the parents and shifted to another beneficiary if the child for whom the account is intended decides not to go to college.

The distinction between custodial account money shifted to a 529 plan and other contributions is a good reason to separate accounts. College savings plans accept only cash deposits, so you'll have to sell the stock, mutual funds or other investments from the custodial account and pay capital gains taxes on any profits, to shift the money.

Does the amount put into a 529 plan from a custodial account qualify for a state tax deduction?

That depends on where you live. Only 28 states let residents write off contributions to the state's own plan. In most cases, it's the child who gets the deduction when shifting custodial account money into a 529 plan. Remember, it's the child's money. But a few states may allow parents to claim the write-off. For a list of states offering tax deductions for 529 contributions, click the following link... www.savingforcollege.com

My state, Iowa , offers a tax deduction for the first $2,375 in 2005, per beneficiary, deposited in its 529 plan, but I prefer the investment options in another state's plan. Can I contribute $2,375 to Iowa 's plan to get the deduction and then put another $8,000 in the other state's plan? Can I put $2,375 in my state's plan, claim the deduction, and then shift the money to the other plan?

There's no problem splitting your contributions among different states' plans. But check the deductibility rules carefully. Some states let each spouse take an income tax deduction for contributions, so you might double your deduction by opening up two accounts in your own state before moving on to another state. Your ' claim the deduction then move the money' strategy might work, but some states "recapture" the tax savings. Again, check with the specific state plan's administrator, as some states have recognized this loophole and are working to close it.

If multiple individuals contribute to a 529 plan for one child, such as parents, grandparents, uncles and aunts, who controls the assets in the plan?

Each account has an owner, or joint owners, and that person controls the assets, regardless of how many people contribute. The owner doesn't have to be a parent.

Since investing in a 529 plan, other plans look better and less expensive. Is there a penalty to switch plans?

New rules make it easier to shift from one state's plan to another. In the past, this was allowed only when changing the beneficiary of the account. Now you can move money as often as once a year for any reason.

Contact the plan you'd like to switch into to get the forms you'll need to make the transfer. Because many states continue to improve their plans, it's smart to check out the options every year or so.

Can college savings in a 529 plan be used for tuition expenses at a Canadian university?

You can use the money at 771 foreign colleges, including the University of Toronto , McGill in Montreal and many other Canadian schools. If U.S. students at the school qualify for federal financial aid, you can use the 529 plan or ESA money to pay the bills without worrying that you'll lose any of the tax benefits.

Can I contribute to both a 529 Plan and an Education IRA (now known as Coverdell Education Savings Accounts)?

Starting in 2002, you can contribute to both for the same beneficiary in the same year. You may wish to fund both, especially if you want to fund some non-college education expenses.

I've set up a 529 college-savings plan for a grandson. What will happen if I die before he withdraws the money?

That depends. You can name a successor owner of the account, and on your death all rights of ownership and control over the account would pass to the new owner. With most 529 plans, you can name a successor on the initial account application or do it later. If you die without naming a replacement owner, the plan may specify that the beneficiary of the account, in this case your grandson, will become the account owner. If the beneficiary is a minor child, the plan may designate the child's living parent or guardian as owner.

If there is no clear successor under the terms of your account or the rules of the program, ownership will pass according to your will or your state's law of intestacy. Residents in states with community-property laws should definitely seek advice about handling a 529 account.

To view more information regarding the 529 Plan and the 529 Plan for each state, click on the following link:

www.savingforcollege.com

In General - The consequences to a Taxpayer or a Designated Beneficiary resulting from contributions to and withdrawals from a 529 Plan will vary from state to state, although the income tax laws of most states conform to federal income tax laws. If a state's income tax laws do not conform to federal income tax law, the tax consequences to the Taxpayer and Designated Beneficiaries may be unclear. Taxpayers and Designated Beneficiaries should consult our firm with respect to the tax consequences of making contributions and/or withdrawals from a 529 plan.

Where to go for information:

www.savingforcollege.com -- all the information you'll ever need to know about 529 Plans

www.collegesavings.org -- College savings plan network – general information about saving for college

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