Section 529 Investment Plans

Save for college

    Section 529 plans were already the best way to save for college. Under the new tax law, withdrawals will be completely tax-free. If you're saving another way, it's time to switch.

    The best college savings plan just got better. In fact, you may want to rethink your entire college-savings strategy.

    The reason is that, starting in 2002, the new tax law makes withdrawals from Section 529 college investment plans completely tax-free, if the money is spent on qualified educational costs. There isn’t a better deal around.

    Congress authorized Section 529 investment plans in 1996. They were designed to complement the already-existing prepaid tuition plans that many states had set up. Prepaid tuition plans offer a guarantee that a regular plan of savings will mature to guarantee paid semesters of college, no matter what the effect of inflation on future college costs. The 529 investment plans add a degree of risk, because the ultimate value of the account depends on the choice of investments within the plan. But even with that risk, state-sponsored Section 529 investment plans have some great advantages over other college-savings techniques.

Section 529 plans are very flexible.

     The money in a Section 529 investment plan can be used for college expenses at any accredited college in any state. By contrast, prepaid tuition plans work best with in-state schools because most plans don’t credit a large cash-value buildup to these accounts. And Section 529 plan assets can easily be transferred between family beneficiaries. If one child doesn’t use the money for college, you can easily designate another recipient -- even a cousin, or a niece or nephew. Grandparents who set up the plans can switch the money between grandchildren. Or you could set up your own plan and later transfer the assets to your child.

Section 529 plans offer control.

     If you save for college using Uniform Gifts to Minors Act (UGMA) accounts, parents lose control over the money when the child reaches the age of majority at age 18 in most states, 21 in others. You may have been saving for Princeton; she may buy a Porsche! With a Section 529 plan, the giver retains control over the assets until they are distributed to pay for college.

Section 529 plans have estate tax advantages.

    Although most plans will be started with small initial investments and regular contributions, the law allows one-time gifts of as much as $55,000 to a Section 529 plan. The giver can aggregate five years of the allowable $11,000 annual gift-tax exclusion to jump-start a Section 529 investment plan. Wealthy grandparents might consider making a large gift to get cash out of their estates -- if they aren't worried about needing the money for their own expenses as they age. (Or unless they’re worried the grandchild will be a dropout, uninterested in college.) Because the donor retains control over the gift, it can be taken back at any time after paying a federally mandated 10% penalty.

Section 529 plans have financial-aid advantages.

      Assets in these plans are not considered a student asset in the formulas used to determine financial aid. By contrast, assets held in UGMA custodial accounts are considered student assets -- and are counted seven times more heavily in the financial aid formula when you fill out the dreaded FAFSA (Free Application for Federal Student Aid). Until the 2001 legislation, withdrawals from a Section 529 plan might have been considered income to the student. But now that withdrawals can be made tax-free and no 1099 form is sent out, withdrawals have no effect on a student's assets. Moreover, if the grandparents have established the plan, it need not appear even as a parental asset on the FAFSA form.
 

Section 529 plans have no limit on parental income.

     Many other college savings plans either limit the amount of contributions each year or place restrictions on parental income. Section 529 plans have very high limits: a one-time $55,000 contribution per donor, and state-imposed maximum total contribution limits that range as high as Rhode Island’s $246,000 (although earnings can grow the account beyond that amount). And the contributor does not have to be a parent, grandparent or even a relative. You can make a contribution for any living beneficiary who plans to attend college. If you’re an adult and plan to attend law or medical school, you can contribute your own savings to a Section 529 plan. If you don’t use the money, one of your future children can. And if a child wins money in an accident or medical settlement, some of that money could be deposited to grow tax-free in a Section 529 plan, as long as the settlement allows.


THE ALTERNATIVES  State of Iowa 529 Plan
 

Section 529 vs. custodial accounts.

     The case for using a Section 529 plan is so compelling now that many parents may consider closing their custodial (Uniform Gifts to Minors Act) accounts, paying taxes on any gains and transferring the cash to a new Section 529 account -- where it will all grow tax-free. (In UGMA accounts, taxes on income or gains are paid at the parents’ rate by children under age 14, and thereafter at the child’s rate.)

I    f you’re considering making a switch to a Section 529 plan, you must sell the assets in a UGMA and pay the taxes, because only cash can be invested in a Section 529 plan. Be aware that Section 529 assets transferred from an UGMA account cannot be used for anyone except the original UGMA beneficiary. And you will have more limitations on the money than you’d have in a custodial account. Section 529 plans require you to spend the tax-free money only on a student’s tuition, room and board (whether on or off campus --to the limits established by the school as for cost of attendance purposes), fees, books and supplies. Money taken from a 529 plan and spent for other purposes is subject to a 10% penalty. Custodial accounts have a broader definition of allowed expenditures.

Section 529 vs. Education IRA.

     The 2001 tax law expanded the Education IRA annual contribution from $500 to $2,000. And it increased the phase-out income limit for joint filers who contribute to such an account to $190,000 to $220,000 -- double the limit for single filers.

    Also, the old tax law did not allow students to use the Hope Scholarship Credit or the Lifetime Learning Credit in the same year they withdrew money from an Education IRA. The two credits were created under 1997-tax legislation.

    The law also now allows you to contribute to an Education IRA and a Section 529 plan in the same year.

    Still, it appears that there are only two advantages to an Education IRA -- and they may not be advantages for everyone. With an Education IRA, you can self-direct the investments, much as you would in any other IRA. Section 529 investment plans are limited to mutual-fund accounts offered by the plans. And the new law provides that money saved in an Education IRA can be used for private and religious elementary and secondary schools, while Section 529 assets can only be used to pay for expenses at an approved institution of higher education.

What to do

    Almost every state has linked up with a financial institution to offer a Section 529 plan, and each state has its own enrollment procedures. You can get information in your state usually from the state treasurer's office. Two Web sites provide links to information on each state on how you can enroll in a plan: The College Savings Plan Network and www.savingforcollege.com.   Information available in the attachments.

    Since very few states offer tax breaks on deposits placed in the plan, you should judge the offerings on the basis of their investment alternatives and track records. Many, but not all, of the plans are described at the College Savings Plan Network’s Web site. If you live in a high tax state, such as New York, you’ll want to check the tax advantages of your state plan.

    Peter Mazareas, a Section 529 plan consultant who worked with Congress on the initial legislation and with the Senate Finance Committee on the latest revisions, is even more enthusiastic now that withdrawals will be tax-free. “Much like a 40l(k) plan for retirees, the 529 plan will soon be considered a prerequisite for anyone saving for college,” says Mazareas, who’s with Alliance Capital, which runs the College Bound fund, a 529 plan sponsored by the state of Rhode Island.

    So open an account for your child or grandchild, and tell all your relatives that contributions are welcome in place of toys or clothes that your child will soon outgrow. This is a gift that keeps on growing -- and tax-free, at that!