Section 529 College Savings Plans
Revised By: Karen Rinehart, CFP®
The Henssler Financial Group Position Paper

Why Would You Need Them?

Current average total costs run from $15,350 for an in-state public college to $30,700 for a private college. From the late 2006 school year to the late 2007 school year, the average college cost increased by 6.6%. Current costs for specific colleges' tuition, books, room and board can be found on this web site: www.collegeboard.com. Remember, however, that you are incurring some costs while your children are living with you already — activities, sports, eating your food, using your electricity, water, and wearing the clothes you buy them!

What Are They?

Qualified tuition programs (QTPs) are authorized under Section 529 of the Internal Revenue Code. Programs are established by individual states or by private sponsors for tax-free funding of qualified higher education expenses for a designated beneficiary. These programs are available to any U.S. resident, regardless of income level. There are two types of sections 529 Plans: prepaid tuition plans and savings plans. Savings plans offer more flexibility and a wide range of investment alternatives, thus this type is our focus here. Qualified expenses include tuition, fees, books, supplies, equipment, and room and board. This program is more liberal than that of the prepaid tuition programs, which usually does not include room and board. Section 529 Plans cannot be used for elementary or secondary education.

Advantages:

  • Distributions are free from federal income taxes if used to pay for Qualified Higher Education Expenses (QHEE).
  • State tax exemption and/or deduction under some circumstances.
  • You may open accounts in other states besides your own.
  • Minimal, if any commissions, low management fees (depending on specific program, i.e., direct sold plans).
  • Special gift tax treatment — $60,000 limit per individual, $120,000 limit for a married couple, per beneficiary, over a five-year time span.
  • High contribution limits, of more than $230,000 per beneficiary, in some states. This is a big advantage over the annual contribution allowed in an Education Savings Account.
  • Removal of assets from donor's taxable estate. However, if an individual donor places $60,000 in initially, then passes away prior to the completion of five years, a portion will be added back into his/her estate. For example, if a donor dies after three years, then $20,000 will be returned to his/her estate.
  • No income limits or restrictions (unlike the Coverdell Education Savings Account, which is subject to income limits of $220,000 joint, $110,000 individual).
  • You can establish an account for yourself, no matter what your age.
  • Contributor maintains control of the account (i.e., you can take it back or use it for another person related to the original beneficiary, such as a sibling or first cousin. It is not an irrevocable "gift" like custodial accounts).
  • Asset allocation is the method of determining the appropriate investment mix in many plans, depending on the designated beneficiary's age i.e., more weighted in growth investments for a very young child or more weighted in fixed income investments for an older child nearer to college age. For example, Fidelity has seven different portfolios weighted in a mix of stocks, bonds, and short-term bond/money market. The investments are moved to a portfolio with a heavier fixed income allocation as the child gets older.
  • Many plans offer static investment options, as well as asset allocation based on the beneficiary's age. Static options allow the account owner to choose 100% equity investments or 100% fixed income investments.
  • Contributions are professionally managed for you by well-regarded companies such as Fidelity (manages for states including Delaware, Massachusetts and New Hampshire), TIAA-CREF (manages for states including Georgia, California, Missouri, New York and Tennessee), Vanguard (manages for states including Iowa and Utah), and Merrill Lynch (manages for states including Arkansas and Maine).
  • Qualified distributions are federally tax-free.
  • If a scholarship is received, the beneficiary can withdraw any amount up to scholarship amount without triggering the 10% penalty or taxes.
  • Portability and flexibility — acceptable at any accredited post-secondary school in the United States, and the beneficiary can be changed to another family member without paying a penalty. "Family member" is broadly defined to include anyone related to the beneficiary as a brother, sister, parent, grandparent, son, daughter, aunt, uncle, niece, nephew, immediate in-laws or spouse of any of these persons. Half-siblings, stepchildren, and stepparents also qualify.
  • Good alternative to Uniform Gift to Minors Act or the Uniform Transfer to Minors Act (UGMA/UTMA) because parents keep the title to state accounts. UGMA/UTMAs are irrevocable gifts, and the child receives the money and can spend it however he/she desires when 18 or 21 years old, depending on the state.
  • You can contribute as little as $50 per month (with the Maine plan managed by Merrill Lynch) or even $25 per month (with the California plan managed by TIAA-CREF).
  • You can roll over an Education Savings Account to a section 529 Program.
  • Use of Federal Hope Scholarship and Lifetime Learning Credits do not affect participation in or receipt of benefits from the Program.

Disadvantages:

  • Control of investments — you cannot manage the investments yourself. Once you put money into a plan, you no longer have control over how it is invested.
  • Earnings on non-qualified withdrawals (those not used for higher education expenses) will be taxed to you as ordinary income at your rate, and a federally mandated penalty equal to 10% of any investment gains will apply.
  • Inability to purchase specific investments, such as U.S. Treasury STRIPS, to mature in specific years for the projected costs. The fixed income investment options in 529 Plans usually are made up of bond funds. Bond funds will go down in value as interest rates rise.
  • Annual account fees including account maintenance fees, administrative charges, and management fees can range from 60 basis points to 150 basis points.
  • Non-resident owners or beneficiaries may be subject to state income taxes.
  • Some states tax their residents' distributions from other states plans.
  • Taxes have to be paid from funds other than the money removed for the higher education expenses. Money removed for qualified expenses has to be spent on higher education expenses.
  • Each state's 529 Plan must be carefully studied regarding its rollover provisions.

What if the Designated Beneficiary Does Not Go to College?

  • You can leave assets invested in the plan. Currently, there are no age restrictions for the beneficiaries, except in a few plans.
  • Change beneficiary to another family member — a younger sibling or an adult returning to school — without paying any federal income tax or penalty.
  • Make non-qualified withdrawals at any time — owe regular income tax and a 10% penalty on earnings portion of the withdrawal. Penalty-free withdrawals are generally available in event of death or disability of the beneficiary, or if the beneficiary receives a scholarship.

When Should 529 Plans be Avoided?

If you are eligible to contribute to a Roth IRA and you have not saved enough for your own retirement, you should avoid a 529 Plan. Remember, you or your child can borrow money for education, but you cannot borrow money for retirement. You can take early distributions from a Roth IRA for qualified higher education expenses without having to pay the 10% early withdrawal penalty; however, you will owe regular income tax on earnings. Once you have maxed out the contributions to your own retirement plans, then you should consider a 529 Plan. Alternately, if you want to give your child or grandchild a gift that does not have to be used for college, you can use a custodial account. Overall, if you want to direct the investments, custodial accounts or saving in your own name will give you more control over the investment choices.

Problems and Where to Find State-Specific Information

There have been some cases of mismanagement, complaints of poor performance, and excessive fees in some programs. Even managers, such as TIAA-CREF and Fidelity, charge different rates from state to state. To get the truth about a program's fees, get a program disclosure and read the fine print. For state-specific information and web site ratings, go to the URL below:

http://www.savingforcollege.com/states/statecompare.htm.

Bottom Line

Section 529 Savings Programs offer a lot of advantages if you have money you do not anticipate needing for yourself or your spouse, and if paying for your children's or grandchildren's college education is important to you. You lose some control, but you gain a lot in estate planning and tax-free savings. Do your homework, check first into the details of your own state's plan to determine if you are eligible for a state tax deduction. If you decide this is a good tool for your objectives, get into one with low fees, one that will take out-of-state money (if your own state's plan is not desirable), and one with great flexibility in spending the tuition money. For more information regarding this topic, please contact The Henssler Financial Group at 770-429-9166 or comments@henssler.com.

All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
 
©2008 The Henssler Financial Group | www.henssler.com