529 Plans: A College Savings Alternative
As higher education costs continue to soar, many parents find themselves faced with the nagging question, “Will I have enough money to pay for my child’s college education?” Although most people today are likely to agree that an investment in higher education usually reaps its rewards in higher long-term earnings—and, hopefully, greater job satisfaction—one key concern is how to choose a smart savings alternative. 529 plans are flexible investment options with tax benefits.
These state-sponsored plans offer attractive tax benefits and allow you to contribute substantially higher sums than with other savings vehicles, such as the Coverdell Education Savings Account and custodial accounts. The funds may generally be used for any “qualified” higher education expense, including tuition, room, board, fees, books, supplies, and equipment. You don’t necessarily need to be a resident of a state to participate in its 529 plan. In some states, you may even name yourself as the beneficiary, if you are planning to further your education sometime in the future. However, participation does not guarantee admission to college—the prospective student will still have to meet the school’s entrance requirements.
Although many details of these plans vary by state, they generally come in two forms—prepaid tuition plans and college savings plans. Prepaid tuition plans allow participants to “lock in” tuition rates at eligible state colleges or universities with a lump-sum investment or monthly installments. The funds are pooled and invested over the long term, so the earnings should meet or exceed expected future tuition increases. The contract value may also be applied to private or out-of-state schools (although possibly not at full value, depending on the state). College savings plans allow contributions to vary, and the full value of the account can be applied at any accredited institution of higher education nationwide.
Substantial Contributions Allowed. Contribution limits are significantly higher than with other college savings alternatives. Some states allow you to set aside more than $100,000 per beneficiary, and they generally have no age or income restrictions.
Tax-Free Distributions. Earnings grow tax deferred, and distributions are tax free if used for qualified education expenses. In addition, some states offer their own tax breaks, although you may need to be a resident of that state.
Gift Tax Benefits. 529 plans allow you to transfer up to five years’ worth of annual gift tax exclusions in one calendar year, as long as no additional gifts are given to that individual during the five-year period. Individuals may gift up to $70,000 in one year, and married couples may give up to $140,000.
Switching Funds Tax Free. You are able to switch funds from one 529 plan to another 529 plan free of any taxes. This allows you to make such a switch as frequently as once a year without changing beneficiaries, and it also allows interstate plan transfers.
Expanded Beneficiary List. Grandparents may be pleased to learn that under 2001 tax reform, the list of possible beneficiaries has been expanded to include cousins. For example, grandparents with multiple grandchildren can set up a 529 plan for their first grandchild. Should that first grandchild choose to delay pursuing an education, the grandparents may transfer the plan to another grandchild.
Professional Asset Management. 529 plans offer a “hands-off” savings approach. Funds invested in the plan are professionally managed through the appropriate state treasurer’s office or by an outside investment firm hired by the plan.
Penalty for Refunds. A federal 10% penalty may be imposed on the earnings portion of a nonqualified withdrawal in addition to ordinary income tax. However, you may be able to roll over the account to a new beneficiary to avoid a nonqualified withdrawal.
Effect on Financial Aid. Any investment may affect a student’s eligibility for financial aid. Interested organizations are attempting to clarify exactly how 529 plans will affect federal financial aid. For many families who earn less than $50,000 and file 1040EZ or 1040A tax forms, a 529 account may not be counted at all. Others, in higher income brackets, may want to open the account in the parents’ names, since financial aid offices typically count only 5.64% of parental assets compared to 35% of the student’s assets. For more specific information, refer to the particular state plan that interests you, and consult a knowledgeable professional.
The Pension Protection Act of 2006 gave a boost to 529 plans by making tax-free distributions a permanent benefit. Since 529 plans operate under individual state laws, costs and details vary by state. For more information and to compare state plans, do a little “homework” and visit these websites: Savingforcollege.com and Collegesavings.org.
529 plans offer no guaranteed rate of return. Out-of-state plans may have in-state income tax ramifications. Always ask for, and refer to, the program description for complete information, including risks, fees, and expenses. Read it carefully before investing.
Boy? Girl? Or Tuition Payment?
You just received the wonderful news that you and your spouse are going to become parents. Thoughts of the many adventures parenting will bring are swirling through your head. The last thing on your mind may be paying for college, but thinking about it now may save you later. The cost of a four-year degree at a private college can easily exceed $150,000 (Source: Trends in College Pricing—2012, The College Board).
However, even if you are aware of the importance of saving for an education, you may be unsure of available options. The following is an exploration of the most common college savings vehicles:
- 529 Plans. 529 plans come in two forms—prepaid tuition plans and college savings plans. Prepaid tuition plans allow you to buy future tuition at today’s prices. College savings plans, on the other hand, offer tax benefits and a variety of investment options. Earnings grow tax-deferred, and qualified withdrawals are tax free. Nonqualified withdrawals are subject to income tax, as well as a 10% federal income tax penalty.
- Coverdell Education Savings Accounts (ESAs, formerly known as Education IRAs). You can contribute $2,000 annually to an ESA, and funds may be used to pay for elementary and secondary education, in addition to college expenses. One major advantage of Coverdell ESAs is that if the funds are used to pay for qualified education expenses (e.g., room and board), earnings will not be taxed. Certain income limits may apply.
- Series EE Savings Bonds. These types of savings bonds usually can be purchased and/or redeemed at your local bank. They are issued in denominations that are half of the bond’s face value ranging from $50 to $10,000. For example, a $50 bond would cost $25. Depending on your income tax bracket, EE savings bonds may offer state and local tax-deductible interest. When used for qualified education expenses, interest may be free of state and federal taxes, as well. However, they are generally subject to federal income tax and early redemption penalties may apply if the bond is redeemed in the first five years. Another possible advantage to savings bonds is that they may be purchased by anyone for your child, for any occasion.
- Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA). UGMA and UTMA accounts are custodial accounts. You may make unlimited contributions to such accounts, and the funds may be used for whatever purchases you deem appropriate. The UGMA account is particularly useful if you are considering purchasing stocks or mutual funds for your child to help save for education. More specifically, UGMA typically authorizes the transfers of cash, bank accounts, stocks, and mutual funds to minors without the need for an attorney; an UTMA account authorizes expanded transfers, including real estate, and royalties. For both UGMA and UTMA accounts, a portion of the earnings may be tax free or taxed at the child’s rate, generally a lower figure. You may make unlimited contributions to such accounts, and the funds may be used for whatever purchases you deem appropriate.
The last option you might consider when saving for your child’s future education may be a simple bank savings account. Although bank savings accounts may offer immediate liquidity and versatility, there are no tax advantages, and given their low risk, the earning potential is very low. Therefore, when it comes to saving for education, it may not be the most beneficial choice.
So, if you are wondering whether you should begin saving for your child’s education now, the answer is, yes. Regardless of which option you choose, beginning today to save for a child’s education will help ensure your child a more secure tomorrow.