Saving for College
As higher education costs continue to soar, many parents find themselves faced with the nagging question, “Will I have enough money to pay for my child’s college education?” Although most people today are likely to agree that an investment in higher education usually reaps its rewards in higher long-term earnings—and, hopefully, greater job satisfaction—one key concern is how to choose a smart savings alternative. 529 plans are flexible investment options with tax benefits.*
These state-sponsored plans offer attractive tax benefits and allow you to contribute substantially higher sums than with other savings vehicles, such as the Coverdell Education Savings Account (ESA) and custodial accounts. Tax-free distributions from 529 plans may generally be used for any “qualified” higher education expense, including tuition, room, board, fees, books, supplies, and equipment. Due to a provision of the American Recovery and Reinvestment Act of 2009 (ARRA), beneficiaries of 529 plans may also use tax-free distributions to cover the cost of computer equipment and Internet access. You don’t necessarily need to be a resident of a state to participate in its 529 plan. In some states, you may even name yourself as the beneficiary, if you are planning to further your education sometime in the future.
Although details of these plans vary by state, they generally come in two forms: prepaid tuition plans and college savings plans. Prepaid tuition plans allow participants to “lock in” tuition rates at eligible state colleges or universities with a lump-sum investment or monthly installment payment. The funds are pooled and invested over the long term, so the earnings meet or exceed expected future tuition increases. The contract value may also be applied to private or out-of-state schools (although possibly not at full value, depending on the state). College savings plans allow contributions to vary, and the full value of the account can be applied at any accredited institution of higher education nationwide. It is important to note that participation does not guarantee admission to college; prospective students will still have to meet the school’s entrance requirements.
Major Advantages
Substantial Contributions Allowed. Contribution limits are significantly higher than with other college savings alternatives. Some states allow you to set aside over $100,000 per beneficiary, and they generally have no age or income restrictions.
Tax-Free Distributions. Earnings grow tax deferred, and distributions are tax free if used for qualified education expenses. In addition, some states offer their own tax breaks, although you may need to be a resident of that state.
Gift Tax Benefits. 529 plans allow you to transfer up to five years’ worth of annual gift tax exclusions in one calendar year, as long as no additional gifts are given to that individual during the five-year period. Individuals may gift up to $70,000 in one year and married couples may gift up to $140,000.
Switching Funds Tax Free. You may switch funds from one 529 plan to another 529 plan free of any taxes. You are allowed to make such a switch as frequently as once a year without changing beneficiaries, and you may also make interstate plan transfers.
Expanded Beneficiary List. Due to tax reform, the list of possible beneficiaries has been expanded to include cousins. For example, grandparents with multiple grandchildren can set up a 529 plan for their first grandchild. Should that first grandchild choose to delay pursuing an education, the grandparents may transfer the plan to another grandchild.
Other Considerations
Professional Asset Management. 529 plans offer a “hands-off” savings approach. Funds invested in the plan are professionally managed through the appropriate state treasurer’s office or by an outside investment firm hired by the plan.
Penalty for Refunds. A Federal 10% penalty may be imposed on the earnings portion of a nonqualified withdrawal in addition to ordinary income tax. However, you may be able to roll over the account to a new beneficiary to avoid a nonqualified withdrawal.
Effect on Financial Aid. Any investment may affect a student’s eligibility for financial aid. A 529 account, whether owned by a dependent student, a parent, or a Uniform Gifts or Transfers to Minors Act account (UGMA/UTMA), is reported on the Free Application for Federal Student Aid (FAFSA) application as a parental asset. Parental assets are assessed at a maximum 5.64% rate in determining the student’s Expected Family Contribution (EFC). For more specific information, refer to the particular state plan, and consult a knowledgeable professional.
Worth “Studying”
Since 529 plans also operate under individual state laws, costs and details vary by state. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. For more information, and to compare state plans, do a little “homework” and visit these websites: Savingforcollege.com and Collegesavings.org.
*529 Plans are state-sponsored investment programs. There is no guarantee by the issuing municipality or any government agency. You should consider the potential benefits (if any) that your own state's plan (if available) offers to residents prior to considering another state's plan. There may be tax benefits to plans offered by your resident state. As with all tax-related decisions, consult with your tax professional.