SECTION 529 PLANS

Qualified tuition programs, or Section 529 plans, have been in existence in many states and in various forms since 1986. The programs were named after Section 529 of the Internal Revenue Code, which was enacted in 1996. Essentially, these are programs that are operated at the state level and gave the participant a number of benefits that include tax-deferred earnings. In this way, they were akin to a traditional IRA or a 401(k) retirement plan.

The accounts are opened by one person for the benefit of another (i.e., a mother can open one for her son). The custodian doesn’t have to be related to the beneficiary (the person who will be attending college) of the account. The beneficiary can be changed at any time. For instance, you open a 529 plan for your daughter, who decides not to go to college. You can change the beneficiary on the account to another family member of the original beneficiary. The new tax law permitted the term family member to include any first cousins, which is a change from the old tax law that prohibited first cousins as a part of the definition. Or, if your child dies, the beneficiary can be changed. Changes in beneficiary are done without any penalty. As with education IRAs, or investing under the donor’s name, the custodian of the 529 account retains complete control of the money until the time it is distributed. This gives the custodian greater peace of mind knowing that the money that was set aside for college won’t go to fund something else. Plus, with the advantage of being able to change the beneficiary, you ensure that the college money will be used for college. It may just be that the original intended recipient is not the one who winds up using it!

529s also benefited from the government’s recent tax law change. As of January of 2002, any qualified withdrawal will now be completely tax-free for federal income tax purposes.* The withdrawals have been tax-free from state income taxes in some cases. All contributions are made on an after-tax basis; thus, they cannot be deducted. As with the education IRA, the new tax law again coordinates the benefits of the 529 tax-free withdrawals with the HOPE and Lifelong Learning credits so that the distribution from the 529 cannot be used for the same expenses for which the credits are being claimed. Plus, you can now make contributions to both an education IRA and a 529 plan for the same person in the same year. Under the old tax law, this was prohibited. Section 529 plans now exist in all states. Any resident of any state may invest in a 529 plan from any other state. There are also no limitations on the type of university the funds can be used for. There are state-assisted tuition programs that parents can invest in, which we won’t be discussing, that specify that the funds may only be used for in-state colleges and universities. With the 529s, there are no such limitations. Therefore, a child in California whose parents have used the 529 plan to save for college may use the money when the child attends college in Texas, and so on.

529s also allow greater flexibility in the amount of money that can be saved. The limit for education IRAs is $2000 per year. 529 plans don’t have a limit on the amount that can be contributed per year. In fact, the tax laws allow for an individual to give up to $55,000 in one year to the beneficiary of a 529 plan without triggering any gift tax. The catch to this, though, is that the gifting individual cannot give any more money to that beneficiary for the next five years. Essentially, the $55,000 is the gift of $11,000 for five years made all at one time. For married couples, the maximum gift would be $110,000.

Some programs may have a limit on the amount of money that can go into a 529 over the lifetime of the account, which is usually around $250,000. But that shouldn’t be a deterrent to utilizing a 529 plan.

Besides the tax-deferred growth and tax-free distributions, another case for investing in a 529 is that it doesn’t discriminate against the wealthy. This is particularly important because children of wealthy parents are less likely to receive financial aid and grants for college. Unlike the education IRA, which has limits on the adjusted gross income of the donor, the 529s have no preset income limits. Any person with any amount of income can give money to a 529 plan for education purposes. There are times when colleges and universities fail to account for the fact that parents may not be helping their child currently pay for college. Let’s assume that Jim is 18 years old and will be attending his state university in the fall. Even though he will receive in-state tuition rates, the school is still very expensive. His parents have set aside money for Jim in a 529 plan, but have told him that they will not be contributing any other money. Jim is on his own to pay for whatever the money in the 529 plan won’t cover. Jim decides that he is going to apply for financial aid because he doesn’t want to deplete his 529 account. Because Jim is from a wealthy family, the university turns him down. Had Jim’s parents just used the education IRA, Jim would have a very limited amount of money to help him pay for tuition, books, room and board, etc. But by investing in the 529 plan, there is a great potential that Jim’s parents contributed more money to the 529 than they could have to the education IRA.

EXAMPLE:

Billy will be attending college in seven years. His parents establish a 529 plan for him, to which his grandparents wish to contribute. They invest $110,000 in Billy’s 529 plan without having to pay any gift tax. How?

$110,000 / 2 = $55,000

Each grandparent gifts $55,000 to Billy’s 529 plan.

$55,000 / 5 = $11,000

Since the maximum gift without triggering gift tax is $11,000, the $55,000 from each grandparent becomes a five-year gift. They will not be able to give any more money to Billy until the five-year time period has elapsed. At that time, they can give Billy more money if they want.

Fortunately, for those who get turned down for financial aid, there is an appeals process. On the average, 10 percent of those turned down for aid appeal. Out of that 10 percent, half receive an increase in financial aid.

There are some downsides to the 529 plan, though. When compared with education IRAs, there is decreased flexibility in the types of securities you can invest in. While some plans offer age-based portfolios, others offer just fixed portfolios. An age-based portfolio is a method of investing which the younger the child is, the riskier the investments are. As the child grows up and approaches college age, the portfolio changes to a different mix of investments that provide less fluctuation. The goal of age-based portfolios is to achieve a high rate of growth while the child is young and has plenty of years before heading off to college, while reducing the amount of value fluctuation as the child gets older. Plus, as the child gets older, you want to be sure that you can access the money and convert it to cash to pay the tuition bills.

A good rule of thumb is to keep about 80 percent of the portfolio in equities, with the rest in bonds and cash, from the time the child is born until age 12. After age 12, gradually reduce the amount of equity back into bonds and cash to help reduce volatility. By doing this, you also help decrease any impact a market downturn would have on the account.

The ability to move from one account to another requires that you change plan sponsors. As with IRAs, if you do change plan sponsors, you have 60 days to put the money back into a 529, plan without incurring any taxes. However, the government does allow for rollovers of 529s, as long as it done no more than once a year. It used to be that if you were rolling over a 529 you had to change the beneficiary of the account. That is no longer the case. Now, when you roll over the account, you can retain the same beneficiary each time.