By Peter A. Rohr
As a doctor, you take a proactive role in the health of your patients and loved ones. Preventative care and regular check-ups are standard protocol for individuals who want to lead an active and well balanced life. But this behavior should not be limited to one’s health. The same steps should also be taken to ensure the overall well being of your financial portfolio, which can secure the financial stability of your loved ones, including their education.
Years of medical school have taught you that education can be a rewarding but expensive experience. Are you aware that there are savings vehicles available to help prepare you for the cost of your child or loved one’s education? The Pension Protection Act of 2006 delivers a huge benefit to families saving for college. The new law, signed in August 2006, preserves the federal-tax-free treatment of qualified withdrawals from 529 college savings plans, which was set to expire in 2010.
Now that you can invest in 529 plans with an eye toward the future, you may be wondering if a 529 plan is the right investment for you and your family.
Named for the section of the Internal Revenue Code that authorizes them, 529 plans are offered in nearly every state. You can invest in any state’s plan, no matter where you live, and anyone can open a 529 plan account for a child or grandchild — even a niece or nephew. Additionally, 529 plans enable the account owner to withdraw money for eligible expenses at accredited post-secondary schools in the U.S. including graduate and accredited trade schools, such as tuition, fees, room and board, books and other required supplies, free from federal taxes. With such ease of use and attractive tax benefits, 529 plans have quickly become the college savings vehicle of choice for many families, topping other tax-advantaged options such as custodial accounts under the Uniform Gift/Transfers to Minors Acts (UGMA/UTMA accounts) or Coverdell education savings accounts.
The assets in a 529 plan are controlled by the account owner but are not generally considered to be part of the account owner’s estate for federal estate tax purposes. Account owners can manage the investment choices (as allowed by the law), change the designated beneficiary or even take withdrawals, although any earnings on non-qualified withdrawals are subject to federal income tax and a 10 percent federal tax penalty (as well as potential state and local income taxes). By comparison, assets held in UGMA/UTMA accounts, while often used for higher education expenses, are available to a minor the day the minor reaches the statutory vesting age, which ranges from 18 or 25 depending on the state, regardless of whether the money is used for higher education expenses or not. At that point, the child can do anything he or she wants with the assets.
Due to its unique gift and estate planning advantages, a 529 plan is also appealing to grandparents looking to reduce their taxable estate while helping to save for a grandchild’s college expenses. As an investor in a 529 plan, you have the added benefit of being able to make a special IRS election to frontload your annual gifts. This means you can make a one-time contribution to a 529 account that is equal to five years worth of annual gifts without triggering a gift tax or a generation-skipping transfer (GST) tax as long as no additional contributions or other gifts are made to the beneficiaries during the following five-year period. For individuals, that means you can alone contribute up to $60,000 per beneficiary. Or, if you and your spouse want to make a contribution, you can double your contribution to $120,000 without triggering any tax penalties on your estate. If you decide to contribute on an annual basis instead (perhaps each year on the grandchild’s birthday), the annual limit for 2007 is $12,000, or $24,000 for a couple, without triggering gift tax or GST tax penalties.
Many parents and grandparents are concerned that a 529 plan may impact their child’s ability to obtain financial aid. Often, the alternative is true and holding assets in a 529 plan helps maximize the amount of financial aid for which the child can qualify. The amount of assistance a child qualifies for each year is based on expected family contribution (EFC) rules. For example, the assets in a UGMA/UTMA account are treated as belonging to the child, so the EFC formula counts 35 percent of all assets held in a child’s name against the amount of money the family can borrow. With a 529 account, financial aid eligibility is based on who made the contribution. If the parents make the gift, only 5.6 percent of the assets are counted against financial aid. And even better, grandparent contributions to 529 plans don’t count against financial aid at all.
As with a prescription you provide to your patients, it’s important to understand the “side effects” of any type of recommendation. In order to receive the tax advantages of 529 plans, the assets can only be used for qualified higher-education expenses, such as college or postgraduate studies at accredited schools, including public or private universities, graduate schools, community colleges, and accredited vocational and technical schools. On the other hand, a Coverdell account can be used for primary and secondary school expenses, but the tax benefits are less generous.
If a child chooses not to pursue a higher education or does not need the account’s funds because he or she receives a full scholarship, then you can transfer the 529 assets to another sibling or family member – an attractive benefit.
If you believe a 529 plan is a good fit with your family’s individual circumstances, the next step is to choose the right one. Almost all states offer a plan, but there are some significant differences to consider. First, find out if your home state offers any additional state tax benefits with its plan. Then look at the investment menu, long-term performance and fees to make sure the tax advantages are worth it. Every state’s 529 plan is unique, so be sure to evaluate the program features carefully.
While the new Pension Protection Act makes 529 plans an attractive investment option, there are other ways to save for your child or grandchild’s higher education too. Here are two other popular options to consider:
If you are unsure if your child or grandchild will attend college, you may want to consider a custodial account. Custodial accounts under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) can be used for any purpose to benefit the child and may be invested in just about any type of investment, including cash, stocks, bonds, mutual funds and other investment products. These accounts are irrevocable gifts and are not transferable, unlike the 529 plan. When the child reaches the statutory vesting age, the child obtains complete control of the assets.
UGMAs and UTMAs offer fewer tax benefits than a 529 plan. For children younger than 18, the first $850 in earnings each year is tax-free, the next $850 is taxed at the child’s rate and anything above $1,700 is taxed at the custodian’s highest marginal rate. However, the assets in these accounts can be used for a broad range of expenses, including private high school, a car or general savings for the child.
If you know your child or grandchild plans to attend the family alma mater and the school participates in a prepaid tuition plan, this may be an attractive option for your family. By paying tuition fees today, you may realize a savings when your child or grandchild attends the school years from now, when tuition costs have likely increased.
However, withdrawing funds because your child or grandchild elects to attend a non-participating school could result in penalties or lost investment opportunity. For example, some programs will only give you your initial investment, plus or minus a two percent annualized return, which is a poor return on an investment after years of savings. If you find the prepaid option appealing, you may consider using it to cover the tuition and fees and then also invest some in a 529 college savings plan to compensate for other possible expenses.
Choosing the right college savings plan for your child or grandchild requires the evaluation of many variables. Your financial advisor can help you sort through the array of available college savings choices and help you design the right strategy for your family. Being proactive about your “wealth health” will help you obtain your short- and long-term financial goals.
Before you invest in a 529 plan, request an official statement and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the 529 plan, which you should consider carefully before investing. You should consider whether your home state or your designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s 529 plan.
Any information presented about tax considerations affecting your financial transactions or arrangements is not intended as tax advice and cannot be relied upon for the purpose of avoiding any tax penalties. Neither Merrill Lynch nor its Financial Advisors provide tax, accounting or legal advice. You should review any planned financial transactions or arrangement that may have tax, accounting or legal implications with your personal professional advisors.
Peter A. Rohr is a Senior Vice President – Investments and Private Wealth Advisor with Merrill Lynch’s Private Banking and Investment Group in Philadelphia.