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What is a 529 plan?
It’s an investment plan operated by a state designed to help families
save for future college costs. As long the plan satisfies a few basic
requirements, the federal tax law provides special tax benefits to you,
the plan participant (Section 529 of the Internal Revenue Code).
It’s up to each state to decide whether it will offer a 529 plan (or possibly
more than one), and what it will look like. Every state has made this
commitment, although a few are not yet up and in operation.
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Why should I invest in a
529 plan when I can't be sure that my kid will attend a public university
in my state?
There's a misconception that 529 plans are only geared to families that
send their kids to a state school. That's just not true. There are two
general types of 529 plans: prepaid tuition plans and college savings
plans. The states offering prepaid tuition contracts covering in-state
tuition will allow you to transfer the value of your contract to private
and out-of-state schools (although you may not get full value depending
on the particular state). If you decide to use a college savings plan,
the full value of your account can be used at any accredited college or
university in the country (along with some foreign institutions). You
can look up eligible institutions on the Education
Department's school code search page.
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What’s so great about 529
plans?
You’re looking at four main advantages.
First, you get unsurpassed income tax breaks. Your investment grows tax-free
for as long as your money stays in the plan. And when a withdrawal is
taken to pay for the beneficiary’s college costs, the earnings portion
of that withdrawal is taxed to the student. Assuming that the student
isn’t earning hundreds of thousands of dollars running a dot-com company
out of her dorm room, you should save taxes with her lower income tax
bracket. The recent tax law changes make this even better starting next
year 2002; qualified withdrawals are entirely exempt from federal taxes.
Your own state may offer some tax breaks as well (like an upfront deduction
for your contributions or income exemption on withdrawals) in addition
to the federal treatment.
Second, you the donor stay in control of the account. With few exceptions,
the named beneficiary has no rights to the funds. You are the one who
calls the shots; you decide when withdrawals are taken and for what purpose.
Most plans even allow you to reclaim the funds for yourself any time you
desire, no questions asked. (There is a penalty, however, any time you
make a “non-qualified” withdrawal.) Compare this level of control to a
custodial account under the Uniform Transfers to Minors Acts (UTMA).
Third, a 529 plan can provide a very easy hands-off way to save for college.
Once you decide which 529 plan to use, you complete a simple enrollment
form and make your contribution (or sign up for automatic deposits). Then
you can relax and forget about it if you like. The ongoing investment
of your account is handled by the plan, not by you. Plan assets are professionally
managed either by the state treasurer’s office or by an outside investment
company hired as the program manager. You won’t even receive a Form 1099
to report taxable or nontaxable earnings until the year you make withdrawals.
Finally, everyone is eligible to take advantage of a 529 plan, and the
amounts you can put in are substantial (over $200,000 per beneficiary
in many state plans). Generally, there are no income limitations or age
restrictions. Thinking about going back to college or graduate school
in the future? Then set up a plan for yourself! There is no reason why
you cannot be the beneficiary of your own account.
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How will a 529 plan affect
my child's chances to qualify for financial aid?
Guidance from the U.S. Department of Education says that your 529 savings
account is treated as an asset of the parent or other account owner in
determining eligibility for federal financial aid. This means that your
expected contribution towards your child's college costs will include
5.6%, or less, of the value of your account for each academic year. This
is much better than the 35% assessment against assets owned in your child's
name or in a custodial account.
However, the amount of income shown on your child's prior year tax return
is assessed at a 50% rate on the current year's application. So if you
withdraw 529 account earnings to pay this year's college expenses, it
will hurt eligibility next year.
Example: You file the FAFSA aid application when your child is a senior
in high school. Let's say you have a 529 savings account with $20,000
in it, of which $10,000 represents your original contribution and $10,000
is earnings. Your eligibility for federal financial aid this year will
decrease by as much as 5.6% of the account value, or $1,120. Assume there
is no further appreciation in the account and you withdraw $5,000 in the
Fall to pay for the first semester college bills. If you have $15,000
left in the account when you apply for aid for sophomore year, you will
again be assessed up to 5.6%, or $840, of the account value. But your
child's tax return for the previous year now shows $2,500 of income because
the $5,000 withdrawal brought $2,500 of taxable income with it. Based
on a 50% assessment rate, your eligibility for federal aid decreases by
another $1,250. The federal aid formula is actually a bit more complicated
than what is described here.
A 529 prepaid tuition plan works differently in the federal financial
aid formula. Here your investment doesn't show up at all on the FAFSA.
But the benefits paid out will be considered by the institution as a resource
that reduces your child's overall financial "need". The bottom line effect
for most families is a dollar-for-dollar offset in eligibility. That is,
if your prepaid tuition contract pays out $5,000 in tuition benefits this
year, you will be considered as having $5,000 less need for financial
aid. Low income families that qualify for the Federal Pell grant will
generally not be affected by a prepaid tuition plan (but they will be
affected by a 529 savings plan).
It is too early to tell how the new tax law will impact the financial
aid treatment of 529 plans. The income tax exemption for qualified withdrawals
beginning in 2002 will likely lead to an upward adjustment to student's
income computed on the FAFSA for those aid applicants who in the prior
year used withdrawals from a 529 savings plan to pay for college. We may
see no change in how prepaid tuition plans are treated.
Sound complicated? It is. Also consider that the financial aid rules are
subject to frequent change. Finally, remember that most financial aid
comes in the form of loans, not grants, and so you end up paying it back
anyway.
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What’s this I hear about
a penalty on refunds? What happens if my child doesn’t go to college or
if I simply end up with more in the account than he needs for college?
Federal law requires that the 529 plan charge you a penalty if a withdrawal
is not used to pay qualified higher education expenses. Based on IRS guidance,
most states will collect a penalty of 10% of the earnings portion of a
“non-qualified” withdrawal. This means that you will get back 100% of
your principal and 90% of your earnings. The penalty is usually not charged
if you terminate the account because the beneficiary has died or become
disabled, or if you withdraw funds not needed for college because the
beneficiary has received a scholarship.
Beginning in 2002, a new 10% federal penalty on earnings will apply if
you receive a non-qualified withdrawal. The states are permitted to remove
their own penalties, and most presumably will do so, although it may take
a while for the change to be made in some states.
You can change the beneficiary at any time in order to keep the account
going and avoid (or at least delay) taking non-qualified withdrawals when
the original beneficiary doesn’t need those funds.
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That penalty doesn’t sound
so bad. Am I missing something?
What could be worse than the penalty is the fact that the earnings portion
of a non-qualified withdrawal is generally taxed to you, the account owner,
and not to the student. In addition, if you were able to deduct your original
contributions on your state income tax return, you will probably have
to report additional state “recapture” income.
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Can I transfer my existing
Education IRA and U.S. savings bonds into a 529 plan?
Yes, you can accomplish these rollovers without triggering tax, but you
should be careful about ownership issues. For instance, the Education
IRA is owned by your child and so it may not be proper to transfer the
funds into a 529 account that is owned by you. Also, at least until the
end of 2001, the untaxed earnings transferred into the 529 plan will be
subject to tax when withdrawn from the 529 plan (the new law grants you
tax exemption on qualified withdrawals beginning in 2002). Also note that
the tax-free rollover of U.S. savings bonds into a 529 plan requires that
you meet all the qualification requirements for the education exclusion,
including the income limits in the year of the redemption/rollover.
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I thought there were some gift
and estate tax advantages with 529 plans, but you didn’t mention that
as a benefit. Am I wrong?
The gift and estate tax treatment of an investment in a 529 plan is a
good news, bad news situation.
The bad news is that your contribution is treated as a gift to the named
beneficiary for gift tax and generation-skipping transfer tax purposes
and so you need to be aware of this exposure particularly if you are making
other gifts to the beneficiary during the same year.
The good news is that your contribution qualifies for the $10,000 annual
gift tax exclusion and so most people can make fairly large contributions
without incurring the gift tax.
The better news is that if you make a contribution of between $10,000
and $50,000 for a beneficiary, you can elect to treat the contribution
as made over a five calendar-year period. This allows you to utilize as
much as $50,000 in annual exclusions to shelter a larger contribution.
The money (and the growth of your account) gets out of your estate faster
than if you made contributions each year.
And the best news is that the asset leaves your estate but doesn’t leave
your control. This is a truly remarkable benefit when you compare it to
the “normal” gift and estate tax laws. Anyone who is being advised to
reduce their estate tax exposure through gifting, but cannot stand the
thought of irrevocably giving away their assets, can now have their cake
and eat it too. Of course, if you later revoke the account its value comes
back into your estate. Your estate will also have to include a portion
of any contribution made with the five-year averaging election if you
don’t live to the fifth year.
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Can I invest for one beneficiary
in more than one state’s 529 plan?
Sure, no problem. There are a couple dozen states that have 529 plans
without any state residency requirements. You can open accounts in as
many of these states as you want, although in most cases there is little
reason to have accounts in more than two or three states.
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Can I contribute the maximum
amount in more than one state if I want to?
The IRS currently does not require that states count your investment in
other state 529 plans when applying their own contribution limits. And
there are no “contribution police” out there looking for people who are
intent on using multiple states to stuff hundreds of thousands of dollars
into 529 plans as a kind of tax shelter. But you are looking for trouble
if you contribute more on an aggregate basis than you can reasonably argue
might be needed for your beneficiary’s future higher education costs.
Of course, between a pricey private college, medical school, and then
business school you might be able to support a pretty hefty sum. A state
will not want to see its program misused as a tax shelter (its tax status
as a 529 plan could be threatened) and if a state determines that you
have made contributions without the intent to use the account for college
it will terminate your account and perhaps assess an extra penalty.
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