Section 529 college education planning

By Carrie L. Coghill, CFP

College education planning is quickly becoming one of the hottest topics in financial planning. With more and more children going off to college, the competition to get into high quality schools has increased. Along with the increase in competition is the increase in price. The average cost of a college education has increased two to three times faster than the rate of inflation. Currently, costs are expected to continue rising at a rate of five percent per year. Providing an education for our children is a goal for most parents. They want their children to have more opportunities than they had. In addition, providing financial support in order to avoid having their children burdened with debt directly out of school is also a big concern.

Over the years, the government has provided various methods of saving money for the benefit of our children. However, only recently, since 1996, has the government focused on the creation of investment vehicles specifically designed for college education. Anytime the government sees a big problem lurking on the horizon, they tend to address it by offering tax incentives to get people focused on the responsibility at hand. With the skyrocketing costs of college and limited financial aid to go around, the government is already enhancing certain college savings plans that have only been around for a couple of years. One of the most exciting opportunities that exist for college savings is the newly expanding Section 529 Savings Plan.

Of all of the benefits that exist with these state-sponsored plans, the one that has made it the most popular is that anyone can contribute to them, regardless of income levels. Usually, when the government creates a tax advantaged savings vehicle, it is limited to the lower and middle classes. The Coverdell Education Savings Accounts (ESA), formally known as the Education IRA, offers tax-free growth of contributions. However, participation is limited based on your income. If you earn over $220,000 (joint) or $110,000 (individual), you cannot contribute to a Coverdell ESA. With a 529 Plan, the amount of your income will not exempt you from participating.

When raising children, the issue of control is critical. Prior to 1996, one of the only ways to formally designate money for children was through the use of custodial accounts: Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors (UTMA). The problem with these accounts is that the money becomes the child’s at age of majority (18 or 21, depending on the state) for UGMA accounts or age 25 for UTMA accounts. In addition, once the money is placed into the account, it is considered an irrevocable gift. You cannot take the money back. It can only be used for the child’s benefit.

The 529 Plan has solved this problem. As participant in the plan (your child is designated as beneficiary), you maintain control of the money, regardless of your child’s age. What happens if your child doesn’t go to college or runs off to join the circus? You have the ability with the 529 Plan to rename the beneficiary, as long as the new beneficiary is a family member. The definition of family member is liberal. You can rename nieces, nephews, your spouse, and even yourself, if you decide that further education is in your future.

There are tax incentives for investing in a 529 Plan that will allow this money to grow more efficiently. Originally, when the plan was created, it was designed to let the money grow on a tax-deferred basis. In other words, no income taxes on interest, dividends or capital gains would be paid until the money was distributed. This arrangement provided a significant incentive for parents. To make it even better, the Economic Growth and Tax Reconciliation Act of 2001 changed the tax-deferral feature to a tax-free feature. Under the new tax law, no income taxes are due when the money is withdrawn. However, keep in mind that this tax legislation is due to “sunset” (revert back to the tax laws of 2001) on December 31, 2010, unless further legislation is passed to keep it in force. If the tax law sunsets, the 529 Plan will still provide tax-deferred savings.

All of the tax advantages with a 529 Plan are only available if the money is used for qualified educational expenses. If the money is not used for qualified educational expenses, income taxes will be due and a 10 percent penalty is accessed. Therefore, you need to have an understanding of which expenses are considered qualified educational expenses. Some states do not consider books or room and board a qualified expense. It is important to note that if your child receives a scholarship, the amount applied to qualified expenses can be withdrawn from the plan free of penalty.

With the costs of college increasing as rapidly as they have, many parents feel as though they haven’t done enough in preparation to meet this expense. The 529 Plan accommodates this issue by allowing contributions to be accelerated into the plan. When individuals make gifts to one another, whether it’s between parents and children or non-relatives, each individual can gift $11,000 to another, without triggering gift taxes. The number of gifts you give doesn’t matter as long as you don’t exceed the $11,000 limit per person, per year. On the receiving end, the number of gifts you receive is not limited.

However, when it comes to the 529 Plan, you are allowed to accelerate the plan with five years of gifts, or $55,000. As a couple, you can contribute $110,000 in one year. If you maximize this feature, you are not allowed to make any more contributions into the plan for five years. There is tremendous benefit to getting as much money into the plan as quickly as you can in order to take advantage of the tax efficiency of growth. The maximum amount of contributions is limited by the state. Many states have high maximum contribution limits of over $250,000.

The 529 Plan also receives unique treatment for estate planning purposes. Once the money is in the plan, it is considered to be out of your estate. Therefore, although you still maintain control over the asset, if you die, the account is not part of your estate and not subject to estate taxes. Grandparents are finding this to be an excellent estate planning method, without giving up control to their grandchildren.

As mentioned from the beginning of this article, 529 Plans are state-sponsored plans that fall under Section 529 of the federal tax code. However, that does not limit you in which state’s plan you select. Money saved via a 529 Plan can be used in any state, regardless of the state you’ve selected to manage your plan. The management of the plan is the most critical factor to consider when you’re selecting the state’s plan you would like to use. Each state hires an investment manager and provides various investment options. Most states have hired well-known mutual fund companies to manage their plans. As with all other aspects of investment planning, you need to be comfortable with the investment manager’s style and explore their track record.

You’ll also want the flexibility to diversify your college education savings just as you would your 401(k) plan. In many ways, the proper diversification of the 529 plan is even more critical because there is a finite date on which you will need the money. If your 401(k) experiences a significant decline in value prior to retirement, although unfortunate, you may have to postpone your retirement. On the other hand, if the money you’ve accumulated for college declines when your child is 17, you can’t put their education on the back burner. Therefore, take the time to explore what investment options are available with various states.

Many states offer age-based portfolios. These portfolios will automatically rebalance the assets among cash, fixed-income and growth, based on your child’s age. This features changes the allocation of the portfolio to become more and more conservative as your child approaches college age. However, be aware that some states do offer additional tax incentive if you utilize your home state’s plan. These incentives may include a tax deduction for contributions. Unfortunately, Pennsylvania’s plan is still in the developmental stage and is due to be launched sometime before the end of 2002. Preliminarily, Delaware Investments has been selected as one of the investment managers and the contribution limit has been established at $260,000.

The 529 Plan provides individuals with the ability to give the gift of college education to their family members without the restriction and loss of control that had been typical with saving money for the benefit of others.

Carrie L. Coghill, CFP, is president and co-founder of D.B. Root & Company, a financial planning firm based in Pittsburgh.