By: David K. Carboni, Ph.D.,CFPⓇ
529 Plans are tax advantaged education savings plans run by states or educational institutions to help families save for college. With employees trying to balance saving for retirement with funding the kids college educations, it’s important to understand how 529 Plans work. Around since 1996, earnings from 529 plans can be used to pay the costs of qualified colleges nationwide. Unlike Coverdell Education Savings Accounts, there are no income restrictions on who may contribute to 529 Plans. Though contributions are not tax deductible for federal incometax purposes, an account’s growth and distributions are tax-free as long as they’re used to pay for qualified higher education expenses. Qualified expenses include: Tuition, fees, books, supplies, computer technology and special needs; room and board for minimum half-time students. There are no maximum contribution amounts, though some plans have set their own limits.
A number of states consider contributions tax deductible for state incometaxes as long as the contributions are to the in-state plan. For example, in Connecticut an individual may deduct up to $5,000 per year, with married couples filing jointly eligible to deduct up to $10,000 per year, for contributions into CT’s plan.
Generally, your choice of college is unaffected by the state sponsoring your plan. For example, you could be a Connecticut resident, invest in a Utah 529 Plan, to pay for the student’s expenses in a school in South Carolina. Though every state now offers a 529 Plan, not all offer the same kinds of plans. Essentially, there are two types of 529 Plans:
►Pre-paid plans allow you to pay all or part of the costs of an in-state qualified college. These plans may be converted to pay for private and out-of-state colleges. A separate pre-paid college plan for private colleges is called the Independent 529 Plan.
► Savings Plans are like 403b Plans or IRAs where your funds are invested in mutual funds or similar investments. Plans allow you to choose from among investment options. How much your plan grows will depend of how well your selected investments perform.
A 529 Plan feature particularly attractive to parents of college students is that the account-owning parent is able to change the beneficiary to another family member (including the account owner) if the child decides against college or drops out. But withdrawals not used for qualified education expenses are generally subject to incometaxes and a 10% penalty.
Contributions to 529 Plans qualify as “a gift” for gift tax purposes.
Therefore, a contributor may contribute up to $13,000 annually without incurring any gift tax liability, or the need to file a gift tax return. Also, a special election allows contributors to apply the annual exclusion over a 5-year election period ($13,000 X 5 years = $65,000). In this situation, $65,000 is removed from the contributor’s taxable estate if the contributor survives the five year period. Decisions around gift and estate tax consequences of 529 Plan contributions should be reviewed with your attorney and be part of your overall estate plan.
When shopping for a 529 Plan look to your own state’s plan first because the contributions may be tax deductible against state incometaxes. Unless the plan is deficient in other respects, that’s often the way to go. CT’s 529 plan is called the Connecticut Higher Education Trust (a.k.a, CHET) and the low cost provider, TIAA-CREF, is the program’s manager. Along with its low costs, TIAA-CREF has over 90 years of successful investment experience. For details about CHET, visit: www.aboutchet.com. In contrast, some states have broker sold plans that are usually much expensive to cover the brokers’ commissions. For example, Ohio’s broker sold Putnam Plans not only generated higher cost broker commissions, but mediocre performance as well
Limited investment choices may be another reason for consumers to look elsewhere when shopping for a 529 Plan. Also, a recent study of plans by Morningstar pointed out that some Plans have overly aggressive Age-based options. With an Age-based investment option, the plans are suppose to switch from more volatile stock investments to more stable bond investments as the student approaches college age. Never the less, some plans, such as New Jersey’s age based option investment, can still have up to 60% of its assets in equities in the years just before college, and 35% in stocks when the student’s attending college. Not a good choice when tuition bills are due and the stock market takes a dive.
For those seeking more detailed information on 529 Plans, the most comprehensive source available is Joseph Hurley’s website: www.savingforcollege.com. Not over does this site provide answers to frequently asked questions, but it rates the various state plans, summarizes the tax rules associated with 529 Plans, helps consumers compare plans, and is just the best website on 529 Plans period.