A 529 Primer: College Savings Just Got Better

Physician's Money Digest, July 2007, Volume 14, Issue 7

Although 529 college savings plans were a good idea from the start, they were hobbled by a 2010 expiration date for the tax-free withdrawals that made the plans so attractive. As part of sweeping pension reform signed into law by President Bush in August 2006, withdrawals from 529 plans are now permanently tax-free. The Administration's action couldn't have come a moment too soon. Investments were starting to wane in the plans over the past 2 years as investors began considering other options to save college funds for their children.

The 529 college savings plans are named for their place in the federal tax code and come in two varieties— 529 college savings plans and 529 prepaid tuition plans. Prepaid tuition plans are just that—taxdeferred savings plans that guarantee your child's tuition will be paid based on today's cost.

A 529 college savings plan allows college savings to grow tax-deferred and withdrawals are completely tax-free as long as the money is used to finance college expenses. Each plan has various investment choices that range from low- to higher-risk, and it's critical to discuss any plan's offerings with an expert first.

Financial Aid & Tax Issues

The Deficit Reduction Act of 2005 prevents a 529 account from being treated as a student asset on a Free Application for Federal Student Aid (FAFSA), which could limit the student's chances for aid. Also, a taxfree distribution from a 529 plan to pay current-year college expenses won’t impact income levels that could reduce financial aid eligibility in the next school year.

Federal tax law allows an individual to contribute up to $60,000 per beneficiary in a single year and a married couple up to $120,000 per beneficiary without incurring gift tax. If you give the full amount, you will not be able to give any gifts to the same individual during the 5-year period without incurring gift tax or using up a part of your lifetime exclusion.

Passing on Funds

If a beneficiary doesn't need the money for college, everyone on the beneficiary’s so-called "lineal family tree"—parents, aunts, uncles, brothers, and sisters as well as kids—may benefit from the tax breaks and educational rewards of these plans. And, depending on state laws, relatives and friends may get a tax benefit for contributing to a particular beneficiary's plan. This is one of the more attractive aspects of the 529 plan— the person who opens the account retains control of the funds. That means that parents can keep control of this substantial asset until the funds are spent. The holder also has the power to transfer accounts or excess amounts to pay for higher education costs for other children or other lineal family members.

There is one area where the choice of a 529 isn't always a lock. There are mutual funds and other investment choices that may earn more for your future student and outweigh any of the tax advantages you get with a 529 plan. It’s particularly important to work with a planner who knows your financial situation and goals before you invest.

Nearly all states have 529 plans and roughly 30 states provide additional incentives, such as a state-tax deduction to in-state residents who invest in their respective plan. It's a good idea to have your financial advisor help you sort through the details of various state plans. There are a variety of services, including Morningstar Inc (www.morningstar.com), that rank the offerings of each state's plan. Savingfor College.com and finaid.org are leading sites that can help educate you in how these plans work.

Reprinted with permission from the Financial Planning Association (www.fpanet.org), the membership organization for the financial planning community.