Articles and Tips

Section 529 College Savings Plans:
A Real Solution For Meeting Tuition Costs
by Peri Ann Aptaker, Esq., CPA/PFS, CFP, CBA

A 529 plan is an investment plan operated by a state designed to help families save for future college costs. Under Internal Revenue Code section 529, the federal tax law provides specific tax benefits.

These plans are especially desirable for high-income families with little chance of qualifying for financial aid. Here is how they work.

The beneficiary can be anyone the owner of the account designates (including him or herself). When the beneficiary is ready to attend college, money is withdrawn to pay qualified education expenses including room, board, fees, tuition and supplies. These withdrawals are taxed as ordinary income at the beneficiary's income tax rate through 2001. Under the recent tax law changes, beginning in 2002, qualified withdrawals are entirely exempt from federal taxes, hence a major incentive to participate in the plan! Individual states may offer some tax breaks as well, for example, a tax deduction or tax credit for contributions made.

The beneficiary can attend almost any qualified higher education program in any state - not just the state where the account is held.

What if the beneficiary decides not to go to college? The owner of the account can easily change the designated beneficiary to another relative of the beneficiary (self, parents, children, and in-laws). If no one in the family attends college, the owner of the account can withdraw the money and pay income tax on the appreciation after payment of a 10% penalty tax (this penalty is waived for death or disability of the beneficiary).

There are other advantageous aspects of these plans. Each year one can make a gift of $10,000 into the plan for the benefit of the beneficiary, which is considered a completed gift for gift tax purposes. If the owner of the account passes away, the money is not included in the owner's estate. In addition, these contributions do not deplete the owner's lifetime gift tax exemption, or the $1 million generation skipping tax exemption. Under current law, a taxpayer can transfer up to $10,000 each year tax-free to any individual using the annual gift tax exclusion. Under the new tax law, beginning in 2002, the first $1,000,000 of one's gifts are exempt from tax. These tax benefits are not affected by the college savings plan.

Congress has made these plans even more attractive by permitting five years of contributions to be front-loaded. So, one generally can invest $50,000 into an account today, and effectively remove for estate planning purposes the appreciation of those assets from one's estate.

Each state has limits on the total amount of contributions that may be made on behalf of a single beneficiary however, there is no limit as to how large these accounts can grow. One could feasibly invest $50,000 into an account today for the benefit of an infant that could eventually pay for undergraduate school, graduate school, law school, and even medical school!

These plans are not perfect since they are included as assets of the beneficiary on a financial aid application, and may disqualify him or her for such college aid. Moreover, once money goes into the plan, control is lost over its management.

All 50 states have qualified state tuition plans. Each state uses an asset allocation strategy tied to the age of the beneficiary and particular investment objectives - so an account for a 17-year old is invested more conservatively than one for a 5-year-old. Eligibility, schools covered, exemption from state tax, investment policies, fund expenses, and other provisions vary from state to state. Each plan should be carefully evaluated. Finally, you do not have to put all of your eggs in one basket since accounts for one beneficiary can be established in several states.

Funding a college education, which is no longer a luxury but a necessity, is one of the biggest financial concerns facing many families. Parents with young children today will encounter estimated four-year college expenses in excess of $200,000. A qualified state tuition program is a new and increasingly popular savings initiative designed to help cover the enormous costs of college. Depending on one's circumstances, the substantial income and estate tax benefits in these plans may far outweigh the lack of control over such an investment.