Education Planning and Sec 529 College Savings Plans

According to the Conference Board, the price of one year at the average four-year private college, including room and board, now exceeds $25,000, and the price for an in-state resident at the average public college approximates $11,300. The rate of increase over the past ten years has been more than 5% per year.

Since 1980, college prices have been rising at a rate two to three times the increase in the CPI. If this trend continues, the price of an education at a four-year private institution for the student enrolling ten years from now will exceed $150,000, and the price of four years at a public institution will be more than $60,000. Median family income has not increased nearly enough to keep pace with rising college costs.

Today, higher education is considered a national priority worthy of public subsidy. The nature of the subsidy has shifted to one that provides incentives to individuals, rather than direct support from institutions. And more than ever before, federal and state governments are using the tax laws as a means of distributing education incentives. These tax law provisions are meant to encourage individuals to save on their own for college.

The turnaround in education-friendly tax legislation has been remarkable. Before 1996, there were a few tax breaks, such the Series EE US savings bond program, the exclusion of up to $5,250 for employer-provided educational assistance and the income exclusion allowed for certain qualified scholarships.

Since 1996, Congress has created three new and very significant ways to invest for college and save taxes at the same time:

  • Using a Roth IRA
  • Saving with a Coverdell Education Savings Account (formerly Education IRAs)
  • Saving with a 529 plan

And the tax law offers new government subsidies for the expense of attending college, including the Hope Scholarship and Lifetime Learning credits and the renewed deductibility of interest on college loans.

The focus of this article is on the option to save for college costs by using qualified state tuition programs established under section 529 of the Internal Revenue Code. This is because there is no other tax-advantaged program that provides the combination of benefits that a 529 plan does.

These plans come in as many different forms as there are states that sponsor them. While intended to provide a way for families of any income level to save for college, the plan also has investment, tax, retirement, and estate planning implications that reach far beyond this one purpose. And these benefits were enhanced by the Economic Growth and Tax Relief Reconciliation Act of 2001 and IRS Notice 2001-55.

Forty-eight of the fifty states now have 529 plans in operation or under development, with about 35 states making their plans available to non-residents. And many states are offering both varieties of 529 plans, a Prepaid Tuition Plan for residents and a Savings Plan open to residents and nonresidents.

While the balance of this article will discuss 529 Savings Plans, it should be noted that while Savings Plans have the advantage of unlimited investment potential, Prepaid Tuition Plans have the advantage of keeping up with inflation of college expenses.

What’s so great about 529 Savings Plans? In a nutshell:

  • Income tax advantages: Earnings in the account are tax-deferred until they are distributed in the future. And under the 2001 Tax Act, distributions are exempt from federal income taxes (rather than being taxed to the beneficiary of the account - generally your child or grandchild - as under prior law) if used for qualified higher education expenses i.e. tuition, fees, books, supplies, certain equipment and a limited amount of room and board.
  • Estate and gift tax benefits: Your contribution to the 529 plan is treated as a completed, present-interest gift for gift tax purpose. This means that the money is not included in your taxable estate, and the gift qualifies for the $10,000 annual gift tax exclusion.

And a special election allows your contribution to be treated as if it were made over a five-year period for gift and generation-skipping transfer tax purposes. This means that $50,000 can be contributed to a 529 plan account gift-tax free (assuming you make no other gifts to the beneficiary of the plan during that five-year period.

  • Availability and flexibility: Unlike so many tax breaks that are subject to income limitations on the taxpayer, a 529 plan imposes no income limitations. Over $100,000 can be invested in accounts for a single beneficiary. Compare this to the $2,000 annual limit on contributions to a Coverdell Education Savings Account (formerly Education IRAs).

Despite the treatment of the account as a completed gift for estate tax purposes, you still retain ownership and control of the account. As the account holder, you can change the beneficiary of the account to another member of the beneficiary’s family, including yourself. You can even demand that the account be returned to you, although you will be subject to a 10% penalty and the investment income will be taxable to you. Nevertheless, given sufficient time, the penalty could be more than offset by the compounding of the investment returns on a tax-deferred basis.

You (or your parents for their grandchild) can establish an account. You can establish more than one account for the same beneficiary and you can make tax-free rollovers from one state plan to another state plan, if you are not satisfied with the investment performance. Further, you can now make annual changes in the investment strategy selected once per calendar year and upon a change in the designated beneficiary of the account.

  • Investment Benefits: Some states offer investment programs that are guaranteed to keep up with increases in tuition cost, others offer a menu of investment options ranging from low-risk bond funds to higher-risk stock funds, while still others use portfolios allocated among stocks, bonds and money market funds tailored to the age of the child beneficiary.

Most states have no residency requirements. This means that your investment options are not limited to your home state 529 plan, but allow you to choose among the investment options of the 35 states that do not have residency requirements. Remember that every state’s 529 plan allows your investments to be used at colleges and universities located anywhere in the US (and many foreign institutions as well). While some programs may provide better benefits to the in-state schools, none lock you in to a specific institution or state public education system.

Many states exempt the earnings on the account from income tax in that state, and several provide a deduction for all or part of the contribution. Note that if you contribute to a 529 plan other than your state’s 529 plan, you will not be taxed by that other state on the investment income.

  • Asset Protection: In some states, the account is given special protection from the claims of creditors, either be statue or through the incorporation of a “spendthrift provision” in the program trust document.
  • Financial Aid Considerations: The federal financial aid treatment of assets in a 529 Savings Plan is more favorable than a Prepaid Tuition Plan. The value of the 529 Savings Plan account should be considered an asset of the account owner. If the account owner is the beneficiary’s parent, the value of the account will be assessed at a maximum 5.6% rate, and if the account owner is the grandparent or some other relative it will not be assessed at all on the asset side of ‘expected family contribution” equation. Note that how withdrawals will be handled is uncertain at this time, in light of change made by the 2001 Tax Act, making distributions tax-free rather than taxable to the account beneficiary.

Beyond the basic distinctions between the two types of plans, there are numerous differences in program design among the various 529 Savings Plans in operation today. Thus, the analysis does not merely involve a comparison of the particular investments being offered by the program, but also the operational aspects of the plan will need to be considered, such as designated beneficiaries, account ownership, state residency requirements, minimum and maximum contributions, payment methods, time limit on use of the account, eligible education expenses, payment of qualified higher education expenses, effect on financial aid eligibility, changes in designated beneficiary, rollovers between 529 plans, non-qualified withdrawals (refunds), penalties, fees, creditor protection, state income, inheritance and gift taxes, other state benefits, program administration, satisfaction with the program and whether the plan applied for a ruling from the IRS to determine its qualification under section 529.

Two recent changes have now provided professional advisors the ability to adjust both the asset allocation and investment options on an ongoing basis, rather than only on the initial selection of the plan.

The first change, included in the 2001 Tax Act and starting in 2002, allows a same-beneficiary rollover to another state’s 529 plan as often as once in a 12-month period. This now allows the account holder to change the investment option, despite the general prohibition against participant investment direction that remains in the law. Prior law required that the beneficiary had to be changed to another family member as part of a qualifying rollover.

The second change was provided in IRS Notice 2001-55. This notice permits a change in the investment strategy selected for a Section 529 Savings account once per calendar year (and upon a change in the designated beneficiary of the account) It is expected that the final regulations will also provide that to qualify under this special rule, a program must allow participants to select only from among broad-based investment strategies designed exclusively by the program.

These two changes, combined with the ability in many state plans to establish multiples accounts within a single state plan, will allow us to more effectively manage these plans and enhance the experience of our clients.

(Note: In order to meet budgetary constraints under federal law, the provisions of the 2001 Tax Act are scheduled to sunset after December 31, 2010. Unless extended, the amendments made by the Act will disappear and we will go back to the tax rules as in effect prior to the effective date of the new law.

This means that 529 plan withdrawals will no longer be tax-free, beginning in 2011. Congress will need to address the issue of extension legislation, and the sooner the better. It is generally assumed that many of the changes made by the Act will in fact be extended, but the questions of which ones will survive, and under what new restrictions and requirements, cannot be answered at this time.)

(This article was written by F. Dennis De Stefano and originally appeared in the January 2002 issue of both the NAPFA Advisor and The Advisor’s Network.)