The authors detail why 529 investment plans offer the best combination of savings and tax advantages for college.
by Marvin Appel, PhD and Brian Hufford, CPA, CFP
The 2001 tax changes contain provisions that could be more valuable to families saving for college than the more publicized education IRA. Unlike education IRAs — which have the same provisions throughout the country — each state sponsors its own 529 plan, with different tax benefits, different contribution limits, and different investment options. The federal tax benefits are uniform, however, and are potentially more valuable than state tax considerations.
In some ways, 529 plans far and away offer the best tax subsidy to college savings, and offers some other legal protections as well. However, as with any investment program geared to reducing taxes, there are drawbacks that are not present in taxable accounts.
Tax-deferred becomes federal tax-free in 2002
The 2001 tax law states that from 2002 to 2011, any earnings on investments in 529 accounts will not only be tax-deferred, they will not be taxed at all as long as they are used to pay for qualifying education expenses — tuition, room, board, books, and supplies. In order to qualify for this tax benefit, the child's account may need to be established for some time (three years in New York State or one year in Virginia, for example) prior to the first withdrawal.
Unfortunately, this provision of the new federal tax law, like all others, is set to expire automatically in 2011 unless Congress agrees to extend the benefits. If the new rules are not extended, the original 529 provisions would resume. Withdrawals for qualified education expenses would be subject to income taxes at the ordinary income tax rate that applies to the student. (For parents or other donors in higher tax brackets who are paying expenses for students in much lower brackets, this might still offer a significant tax savings.)
Withdrawals made for expenses other than education are subject to ordinary income tax rates and also to a penalty tax of 10 percent. For example, parents in a 35 percent tax bracket who withdraw from a 529 plan for non-educational expenses would have to pay federal tax of 45 percent of the investment profits.
State tax benefits
For those of you who live in states with an income tax, you can generally deduct contributions to your state's plan from your state-taxable income, up to a specified limit.
Each state selects its own mutual fund company to run its plan. Each plan has a different set of investment options, and pays different fees to the designated mutual fund. The list of plans for each state is available on the internet on at least two informative sites:
Collegesavings.org is sponsored by the National Organization of State Treasurers. Savingforcollege.com is a private site maintained by an accountant, Joseph Hurley, on which he also promotes items or services for sale. Fees charged and investment options are available on links from either of these sites.
Donors can contribute to any plan, not just those from their own states; savings in any state's plan can be used for colleges anywhere in the country. The main issues favoring one state plan over another are the tax benefits available for using the plan in your home state, the amount you are allowed to contribute, and the investment options.
Most 529 plans have a program that includes stocks, bonds, and cash. The proportions change as the student approaches college. For a young recipient, a majority of the portfolio might be in stocks. As the student nears age 18, the funds are shifted into secure investments such as bonds or cash. Once a contribution is made into such a plan for a student, the portfolio goes on auto-pilot according to the schedule and plan established in advance by the fund manager.
Other choices generally available include a money market or a portfolio that always contains a minimum proportion of stocks regardless of a student's age. The main drawback of a 529 plan is that, once contributions are made to a certain investment program, they can be reallocated to different investment portfolios only once each year.
Investors cannot move the funds from one plan to another. You are subject to the fees and investment performance of the plan manager once you contribute. Also, states may switch fund managers when their contracts expire. (Many 529 plan investment managers are familiar names, including TIAA-CREF, Vanguard, Fidelity, Salomon Smith Barney, etc., but these firms' 529 plan offerings are not necessarily the same as any of their retail mutual funds.)
Donors do have a bit of control. They can direct their new contributions to any plan. Donors can contribute funds at any time of year; they can also allocate small contributions throughout the year. Finally, withdrawals can occur from any 529 plan holdings in whatever order or amounts the account owner desires.
Who controls the money?
Unlike a direct gift to a child, the donor "owns" the 529 plan and has control over when and how much to disburse at any one time. The account owner can request direct payments to an educational institution. If the designated recipient decides not to go to college, 529 plan assets can be left in the account to pay for other types of higher education (up to age 30) or can be transferred to another student. Legal protections from creditors exist for some of the assets in 529 plans; check with your financial adviser.
How much can I contribute?
Any donor can contribute to a 529 plan, regardless of income level. Each state sets its own limit on the amount of plan contributions that are tax-free, and may also limit the total contribution to any one account. In New York, for example, a couple filing jointly can write off up to $10,000 per year from state income taxes. Contributions beyond this amount will not have any additional tax benefit. New York limits the lifetime contribution to any one student to $100,000. Virginia, on the other hand, allows donors to deduct $2,000 per year per student. Contributions beyond that amount may be carried forward for future Virginia state tax benefits.
Gift and estate tax
Although the donor is the "account owner," contributions to a designated beneficiary count as gifts to the recipient. This means that contributions to a 529 plan must be included in the $10,000 gift limit per recipient per year. As with other gifts, if both parents transfer assets, each child can receive up to $20,000 per year, including contributions made to a 529 plan on a child's behalf.
Parents actually can contribute up to five year's worth of gifts at one time, therefore using five years of gift tax exemptions in advance. The potential benefit of such a move lies in the greater use of the tax deferral or exemption of investment earnings. However, it does reduce flexibility with future gifts should the donor or recipient's circumstances change. Conceivably, the ability to make gifts in advance could be of value to parents whose children are close to college age. If a donor dies within five years of making five year's worth of gifts, estate tax will be due on a pro-rated portion. Donors in poor health should not attempt to use this as a loophole for estate taxes.
We recommend caution when making large, up front contributions to 529 plans. This is especially important for individuals in states where the tax laws benefit who donors spread out their contributions over a greater number of years.
Currently, only $500 per year can go into an education IRA, although this amount increases to $2000 next year. Education IRAs have income requirements and are not always favorable to those in a higher tax bracket. Education IRAs do enjoy greater investment flexibility than 529 plans, and the tax exemption on distributions (for qualified expenses) is not subject to automatic expiration in 2011.
In 2001, donors cannot contribute to both a 529 plan and education IRA for the same student. Beginning in 2002, however, a student can receive contributions in both plans.
Despite the outward attractiveness of 529 plans, uncertainty in the tax code and the lack of investment flexibility should give pause. Investors who contribute to accounts for students beginning college between 2002 and 2011 should strongly consider making large contributions to 529 plans if an appropriate investment option is available for your situation. The potential benefits of using a 529 plan will vary from state to state, depending on each state's tax laws and 529 plan investment options. For those of you with younger children, contributions to 529 plans may represent a bit of a gamble on whether the tax exemption will be extended. The trade-offs between 529 plans, education IRAs, or non-qualified investments will vary, depending on your investment objectives and tax situation.
A conservative savings method for children starting college after 2011, especially for those living in states with high income taxes, would be to contribute the maximum amount eligible for deductions from state income taxes each year. If you can save for college beyond that amount, it might pay to place additional savings in education IRAs or tax-efficient, low-cost investments.
You should of course consult your own tax and estate planning advisors, and review the prospectuses of any plans before making any final decisions.