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· 529 College Savings Plans
· 529 for College Q&A
· Coverdell
529 Plans
Most parents and grandparents are "amazed" at what a college education will cost for one child, let alone two or three. In some cases, this can cause paralysis when in fact they need to get started saving as soon as possible. Relief is on its way.
As a result of the Tax Reform Act of 1997, the current "College Savings Plan" (529 plan) was born and has become increasingly popular as more states adopt a plan of their own. Today, almost every state either has a plan in place or legislation pending to enact a 529 plan. While there are still other strategies available such as tuition pre-payment plans, traditional IRAs, Roth IRAs, UGMA, UTMA, Education IRAs, or outright gifting, the 529 plan gives parents a powerful alternative to saving for the high cost of college education.
As with most investment strategies, each of these plans has its advantages and disadvantages that must be weighed in determining the best option. For most parents, a combination of strategies is the best plan of action as well as honing any special skills that the child may have in hopes for a scholarship.
Advantages Of 529 College Savings Plans:
- While contributions of any amount are permitted the owner has the ability to contribute up to $50,000 in one year without incurring the annual gift tax ($100,000 for couples).
- The assets grow tax deferred at the federal level and are taxed at the beneficiary's tax rate when "qualified" distributions are made. Note that "qualified" distributions will vary by state. However, most states allow for funds to be used for tuition, fees, room and board, books, supplies, and equipment required for enrollment.
- Some state programs provide a state income tax deduction of all or a portion of the contribution or a tax credit. Also, some states allow qualified distributions to be exempt from state taxes of the sponsoring state.
- If the beneficiary does not attend college immediately out of high school, or not at all, the account owner has the ability to change the beneficiary to another member of the family. (This could include a cousin, uncle, aunt, or the owner of the plan.) Note that this is a feature that varies greatly from state to state. For example, some states require that the money must be distributed when the beneficiary attains age 30. Some states will not allow the owner of the plan to be the beneficiary.
- Control and flexibility. The money contributed to the plan is removed from the owner's estate. However, the owner maintains control of the account and can access the money any time he or she needs to. Of course, there would be a 10% non-qualified penalty plus taxes on the appreciation.
- There are no restrictions on income. Therefore, families of all incomes can apply. Also, anyone can contribute, including parents, grandparents, relatives or friends.
- Most states allow anyone to use their plan regardless of residency.
- You are not restricted to using a college in the sponsoring state. That means you could live in Kansas, open an account with Missouri's plan and attend college in Illinois.
- In the event of the death of the beneficiary or owner, the assets are not included in the owner's estate.
- The assets in the plan are treated as a parental asset, of which only 5.6% is considered available to cover college costs each year. Also, the plan will not hinder the beneficiary's ability to qualify for the Hope Scholarship or Lifetime Learning Credit.
- Penalty free distributions can occur in cases where the beneficiary dies, becomes disabled, or receives a scholarship.
Disadvantages of "College Savings Plans" (529 Plans):
- The state sponsoring the plan has control over how the money is invested and chooses the investment manager (many states have recognizable asset managers).
- "Non-qualified" distributions, those distributions not used for college expenses, are subject to a 10% penalty and taxed at the owners rate.
- Changing beneficiaries will be subject to gifting laws and generation skipping transfers. However, the generation skipping transfer exemption amount is $1,030,000. So, it is unlikely that this will be of concern to anyone.
- If a beneficiary receives a contribution to an education IRA, he, or she cannot receive a contribution to a 529 plan in the same year.
Determining which 529 plan to utilize depends largely on what the owner is trying to accomplish. For the most part, the owner is trying to fund college expenses under a tax favorable scenario. And for this reason, most individuals are going to opt for their state's 529 plan in order to take advantage of the tax deduction and tax-free growth. However, before you decide totally on your state's plan you need to investigate who is managing the funds. Most states are using proven money managers such as Alliance Capital, Putnam, American Century, Fidelity, etc. Also, you need to investigate the fees involved such as the asset management charge and annual account fee. For those individuals who wish to transfer a significant portion of their estate using these vehicles, Rhode Island provides the highest contribution limits at $246,023. Note that this is a lifetime aggregate contributed to the plan for each beneficiary.
Questions and Answers - 529 College Savings Plans
What is a 529 plan? It's an investment plan operated by a state designed to help families save for future college costs. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant (Section 529 of the Internal Revenue Code). It's up to each state to decide whether it will offer a 529 plan (or possibly more than one), and what it will look like. Every state now has at least one 529 plan available. 529 plans are usually categorized as either prepaid or savings, although some have elements of both.
Why should I invest in a 529 plan when I can't be sure that my child will attend a public university in my state? There's a misconception that 529 plans are only geared to families that send their children to a state school. That's just not true. There are two general types of 529 plans: prepaid programs and savings programs. The states offering prepaid tuition contracts covering in-state tuition will allow you to transfer the value of your contract to private and out-of-state schools (although you may not get full value depending on the particular state). If you decide to use a 529 savings program, the full value of your account can be used at any accredited college or university in the country (along with some foreign institutions). You can look up eligible institutions on the Recent tax law changes now permit higher education institutions to offer their own 529 prepaid programs. These will allow you to target your tuition prepayment to the sponsoring institution (or group of institutions). While none of these programs have begun yet, we could see one fairly soon.
What are the main advantages of 529 plans? First, you get unsurpassed income tax breaks. Your investment grows tax-free for as long as your money stays in the plan. And when the plan makes a distribution to pay for the beneficiary's college costs, the distribution is federal tax-free as well. This treatment applies for distributions in the years 2002 through 2010. Unless Congress decides to extend this tax break, qualifying distributions made after 2010 will be taxable to the beneficiary (earnings portion only). Assuming that the student isn't earning hundreds of thousands of dollars running a dot-com company out of her dorm room, you should still save taxes with her lower income tax bracket. Your own state may offer some tax breaks as well (like an upfront deduction for your contributions or income exemption on withdrawals) in addition to the federal treatment.
Second, you the donor stay in control of the account. With few exceptions, the named beneficiary has no rights to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the "non-qualified" withdrawal will be subject to income tax and an additional 10% penalty tax). Compare this level of control to a custodial account under the Uniform Transfers to Minors Acts (UTMA).
Third, a 529 plan can provide a very easy hands-off way to save for college. Once you decide which 529 plan to use, you complete a simple enrollment form and make your contribution (or sign up for automatic deposits). Then you can relax and forget about it if you like. The ongoing investment of your account is handled by the plan, not by you. Plan assets are professionally managed either by the state treasurer's office or by an outside investment company hired as the program manager. You won't even receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals. If you want to move your investment around you may change to a different option in a 529 savings program every year (program permitting) or you may rollover your account to a different state's program as often as once every 12 months. (There is no federal limit on the frequency of these changes if you replace the account beneficiary with another qualifying family member at the same time.)
Finally, everyone is eligible to take advantage of a 529 plan, and the amounts you can put in are substantial (over $200,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions. Thinking about going back to college or graduate school in the future? Then set up a plan for yourself! There is no reason why you cannot be the beneficiary of your own account, although some investment firms do not presently allow you to do so.
How will a 529 plan affect my child's chances to qualify for financial aid? Guidance from the U.S. Department of Education says that your 529 savings account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution towards your child's college costs will include 5.6%, or less, of the value of your account for each academic year. This is much better than the 35% assessment against assets owned in your child's name or in a custodial account.
However, any distributions from a 529 plan this year may impact a student's financial aid eligibility next year. Student income is assessed at a 50% rate in calculating expected family contribution (after certain allowances). Does a tax-free 529 distribution have to be added as "untaxed income" for federal aid purposes? While logic might say "yes" (at least for the earnings portion of the distribution), the latest word from Washington (November 2002) suggests otherwise. The Department of Education has informally indicated that there are no rules requiring that tax-free 529 distributions be treated as financial aid income or as any other type of adjustment to the student's financial aid eligibility. This position may change, so be careful.
Example: You file the FAFSA aid application when your child is a senior in high school. Let's say you have a 529 savings account with $20,000 in it, of which $10,000 represents your original contribution and $10,000 is earnings. Your eligibility for federal financial aid this year will decrease by as much as 5.6% of the account value, or $1,120. Assume there is no further appreciation in the account and you withdraw $5,000 in the Fall to pay for the first semester college bills. If you have $15,000 left in the account when you apply for aid for sophomore year, you will again be assessed up to 5.6%, or $840, of the account value. Whether your child will be required to report $2,500 of "untaxed" income because the $5,000 withdrawal brought $2,500 of excluded earnings with it, may depend on future guidance. The federal aid formula is even more complicated than what is described here.
A 529 prepaid tuition plan works differently in the federal financial aid formula. Here your investment doesn't show up at all on the FAFSA. But the benefits paid out will be considered by the institution as a resource that reduces your child's overall financial "need". The bottom line effect for most families is a dollar-for-dollar offset in eligibility. That is, if your prepaid tuition contract pays out $5,000 in tuition benefits this year, you will be considered as having $5,000 less need for financial aid. Low income families that qualify for the Federal Pell grant will generally not be affected by a prepaid tuition plan (but they will be affected by a 529 savings plan).
Sound complicated? It is. And we are only talking about the federal financial aid rules here, each school can (and most will) set its own rules when handing out its own need-based scholarships, and many schools are starting to adjust awards when they discover 529 accounts in the family. Also consider that the federal financial aid rules are subject to frequent change. Finally, remember that most financial aid comes in the form of loans, not grants, and so you end up paying it back anyway.
What's this I hear about a penalty on refunds? What happens if my child doesn't go to college or if I simply end up with more in the account than he needs for college? Federal law imposes a 10% penalty on earnings for non-qualified distributions beginning in 2002. This means that you will get back 100% of your principal and 90% of your earnings. The penalty is not assessed if you terminate the account because the beneficiary has died or is disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship.
You can change the beneficiary to another qualifying family member at any time in order to keep the account going and avoid (or at least delay) taking non-qualified withdrawals when the original beneficiary doesn't need those funds.
That penalty doesn't sound so bad. What am I missing? What could be worse than the penalty is the fact that the earnings portion of a non-qualified distribution that comes back to you, the account owner, will be subject to tax as ordinary income at your tax rate. (Some 529 plans allow you to direct the withdrawal to the beneficiary, which would presumably keep it in a low tax bracket.) In addition, if you were able to deduct your original contributions on your state income tax return, you will generally have to report additional state "recapture" income.
Can I transfer my existing Coverdell education savings accounts and U.S. savings bonds into a 529 plan? Yes, you can accomplish these transfers without triggering tax, but you should be careful about ownership issues. For instance, the Coverdell ESA (formerly the Education IRA) is effectively owned by your child and so it may not be proper to transfer the funds into a 529 account that is owned by you. Also, for 529 distributions after the 2010 "sunset" the untaxed earnings transferred into the 529 plan will be subject to tax when withdrawn from the 529 plan. Also note that the tax-free transfer of U.S. savings bond redemption proceeds into a 529 plan requires that you meet all the qualification requirements for the education exclusion, including the income limits in the year of the redemption.
Can I transfer my child's existing Uniform Transfers to Minors Act (UTMA) account into a 529 plan? Many (but not all) 529 plans accept funds coming from an existing UTMA or UGMA. However, because these funds belong to the minor under a custodial arrangement, any withdrawals from the UTMA/529 account must be for the benefit of that minor only. Program rules and state laws will generally prevent you from making any beneficiary changes to the UTMA/529 account, and the minor will assume direct ownership of the account when the custodianship terminates at the age of majority. Parents who are nervous about a child getting their hands on money in an UTMA account, and who may be looking to "regain control" of the money by transferring the funds to a 529 account, may be disappointed to learn that they are not able to accomplish that objective without violating state laws (see your attorney). Still, the placement of UTMA funds in a 529 account can provide all the tax and investment benefits associated with 529 plans. Remember, however, that a 529 plan can only accept cash and so any appreciated securities in the UTMA would first have to be sold and capital gains would be reportable on the minor's tax return.
Are there gift and estate tax advantages with 529 plans? The gift and estate tax treatment of an investment in a 529 plan is a good news, bad news situation. The bad news is that your contribution is treated as a gift to the named beneficiary for gift tax and generation-skipping transfer tax purposes and so you need to be aware of this exposure particularly if you are making other gifts to the beneficiary during the same year.
The good news is that your contribution qualifies for the $11,000 (in 2002 and 2003) annual gift tax exclusion and so most people can make fairly large contributions without incurring the gift tax. The better news is that if you make a contribution of between $11,000 and $55,000 for a beneficiary, you can elect to treat the contribution as made over a five calendar-year period. This allows you to utilize as much as $55,000 in annual exclusions to shelter a larger contribution. The money (and the growth of your account) gets out of your estate faster than if you made contributions each year.
And the best news is that the asset leaves your estate but doesn't leave your control. This is a truly remarkable benefit when you compare it to the "normal" gift and estate tax laws. Anyone who is being advised to reduce their estate tax exposure through gifting, but cannot stand the thought of irrevocably giving away their assets, can now have their cake and eat it too. Of course, if you later revoke the account its value comes back into your estate. Your estate will also have to include a portion of any contribution made with the five-year averaging election if you don't live past the fourth year.
Can I invest for one beneficiary in more than one state's 529 plan? Sure, no problem. There are a couple dozen states that have 529 plans without any state residency requirements. You can open accounts in as many of these states as you want, although in most cases there is little reason to have accounts in more than two or three states.
Can I contribute the maximum amount in more than one state if I want to? The IRS currently does not require that states count your investment in other state 529 plans when applying their own contribution limits. And there are no "contribution police" out there looking for people who are intent on using multiple states to stuff hundreds of thousands of dollars into 529 plans as a kind of tax shelter. But you are looking for trouble if you contribute more on an aggregate basis than you can reasonably argue might be needed for your beneficiary's future higher education costs. Of course, between a pricey private college, medical school, and then business school you might be able to support a pretty hefty sum. A state will not want to see its program misused as a tax shelter (its tax status as a 529 plan could be threatened) and if a state determines that you have made contributions without the intent to use the account for college it will terminate your account and perhaps assess an extra penalty.
Coverdell Education Saving Account
The Coverdell Education Savings Account, formerly known as the Education IRA, is a tax-advantaged way to save and invest for qualified education expenses.
How do I establish a Coverdell education savings account? The first thing to do is determine if you are eligible to contribute to a Coverdell education savings account. The beneficiary of the account must be under the age of 18 at the time of the contribution. There is no requirement that the beneficiary be your child or have any other particular relationship.
Also, your income must be below a certain level in the year of your contribution. Contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. The $2,000 maximum is gradually phased out if your modified adjusted gross income falls between $190,000 and $220,000 ($95,000 and $110,000 for single filers).
Starting in 2002, you can begin contributing to both a 529 plan and a Coverdell account for the same beneficiary if you wish. This was not permitted in past years. The next step is to decide where to establish the Coverdell education savings account. Any bank, mutual fund company, or other financial institution that can serve as custodian of traditional IRAs is capable of serving as custodian of a Coverdell education savings account. Your cash contribution can be invested in any qualifying investments available through the sponsoring institution-stocks, bonds, mutual funds, certificates of deposit, etc (but not life insurance). There is no limit to the number of Coverdell education savings accounts that you can establish for any one child (as long as the total contributions stay within the $2,000 limit), but you will probably find that annual fees and sponsor-imposed minimums make multiple Coverdell education savings accounts impractical in most situations.
You will then need to complete the Coverdell education savings account enrollment forms from the sponsor, including the designation of a beneficiary and a "responsible individual", and make the contribution.
Our income is above the allowable limit. Can our child make the contribution? Yes, there is no problem with having your child, who has income below the allowable limit, make the Coverdell education savings account contribution. You would simply gift the money to the child first. There is no requirement that the contributor have earned income as there is for traditional and Roth IRAs.
Do we have until April 15 of the next year to make the $2,000 contribution, like we do with our traditional IRA?Starting with the contribution year 2002 the law allows you to make your contribution after the end of the year and apply it to the prior year limit as long as it is made before the April 15 tax filing deadline. This rule did not apply for 2001 when the contribution limit was $500.
The $2,000 annual contribution limit doesn't seem high enough, considering how much college is going to cost by the time my child goes to college. Can we have different family members each set up an account and contribute $2,000? The answer, unfortunately, is no. Besides the $2,000 annual limit on how much you can contribute for a particular child, there is also an overall $2,000 annual limit on contributions to Coverdell education savings account for the benefit of that particular child. If multiple accounts are established, and more than $2,000 is contributed in total, the excess is subject to a 6% excise tax penalty. You can eliminate the penalty by withdrawing the excess contributions (and earnings on the excess, taxable to the beneficiary in the year the contribution was made) before the due date of the beneficiary's tax return for that year. If you do not do this, the excess contribution will be subject to penalties in subsequent years unless withdrawn or "absorbed" by unused annual contribution allowances.
Can a corporation, partnership or other non-living entity make the contribution to a Coverdell education savings account? The tax law does not restrict the ability to make contributions to living individuals. The new tax law makes it clear that corporations and other entities may make contributions without regard for the usual donor income limit.
If anyone can establish a Coverdell education savings account for my child, how will we know if more than the $2,000 limit has been contributed? You will most likely be able to find this out after the end of the year when the institutions sponsoring the Coverdell education savings accounts mail out Contribution Information on Form 5498 to your child at the end of the year. If you see that more than $2,000 has been contributed for your child, you know you have a problem.
If my child's grandparent contributes $2,000 to my child's Coverdell education savings account but should not have contributed anything because the grandparent's income was too high, who pays the excise tax? Since the Form 5329 is filed with your child's tax return, it looks like your child is ultimately responsible for the penalty. How would you or your child know whether the grandparent is eligible to contribute $2,000? That is a mystery to us, too.
What's so great about the Coverdell education savings account? Under the "old" tax law, not too much (despite the lure of tax-free income). In 2002, the Coverdell education savings account became a very attractive college savings vehicle for many people, including families that wish to save for elementary and secondary school expenses. In fact, even if you like the 529 plan you may still decide to contribute the first $2,000 of savings for each child into a Coverdell account. There are still some items to be aware of, however, such as the following:
- There are certain eligibility requirements in the year you wish to contribute to the Coverdell account which means that not everyone will find them useful. For example, the age limits mean that older adults with college plans may not be eligible.
- In 2002, the contribution limit increased from $500 per child to the much more reasonable level of $2,000. However, you need to be careful accounts established by different family members for the same child do not cause total contributions to exceed $2,000 or else a penalty will be owed.
- The relatively low contribution caps mean that even a small annual maintenance fee charged by the financial institution holding your Coverdell education savings account could significantly affect your overall investment return.
- Your contribution goes into an account that will eventually go to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans. This means you lose some degree of control.
- The Coverdell education savings account can be a disadvantage when applying for federal financial aid. The account is considered an asset of the student, not the parent. Withdrawals while in college can also produce a harsh effect on the following year's aid eligibility because it is counted as student's income.
- Coordinating withdrawals with other tax benefits, especially the Hope or Lifetime Learning credits, can be tricky. The 2002 changes are certainly an improvement over the 2001 rules, but you still need to pay close attention. The same situation applies to a 529 account starting in 2002.
- The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties.
- The rules are somewhat confusing and the tax forms are complicated. The new tax law will not be much help here. In fact, even the 529 plan will become more difficult to handle on your tax returns beginning 2002 because of the changes.
So how does it work? If you know how a Roth IRA works, then you have a pretty good idea of how an Coverdell education savings accounts works. They both allow you to make an annual non-deductible contribution to a specially designated investment trust account. Your account will grow free of federal income taxes, and if all goes well, withdrawals from the account will be completely tax-free as well. You will need to meet certain requirements in the years you wish to make the contributions, and in the years you take withdrawals. (More on these Coverdell education savings account requirements later.)
But a Coverdell education savings account is an investment vehicle targeted to education expenses, not to retirement.
I don't expect my child to be in a particularly high tax bracket during college or in the years leading up to college. Does that mean I lose the tax-advantage? Well, yes, at least to some extent. But even if your child is in the 15% tax bracket, there's some tax savings to be had. And if you live in a state that imposes an income tax, you may save even more (most states will follow federal tax treatment of the Coverdell education savings accounts).
Some families will find that some portion of a Coverdell education savings accounts withdrawal will be taxable, even when used for college. That's because they may be claiming a Hope or Lifetime Learning credit, or taking the new deduction for tuition payments. The tax law will not allow you to "double-dip" by claiming multiple tax breaks for the same expense.
I'm not sure I understand that part. How can I be sure that I am getting the most tax benefit? The new tax law says that beginning in 2002 your pool of "qualified expenses" for taking tax-free Coverdell education savings account withdrawals is reduced by the tuition you use to claim the Hope or Lifetime Learning credit. This means that some portion of the Coverdell education savings account withdrawal can become taxable. The good news is that you get to choose the approach that provides you the most benefit. The bad news is that your taxes are complicated by the need to figure out which way is best. Tax-free Coverdell withdrawals can also reduce the amount that you might otherwise be able to claim as an above-the-line deduction under a new provision effective for years 2002 through 2005.
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