Many parents today say that saving for a child's higher education has become one of their foremost financial concerns, on the same level as their own retirement planning. Public opinion polls by The College Savings Plans Network, an affiliate of the National Association of State Treasurers, identify a newfound interest by Americans in assuming the responsibilities of planning and saving for education expenses rather than relying totally on government aid programs or personal debt. Fortunately, in recognition of Americans' need to save for college and higher education, the government granted 529 Savings Plans federal tax exemption in 2001, with the provision that they be used according to the specific plan's requirements.
The challenge of saving for college or higher education for a child is not likely to diminish, as college costs continue to rise. According to the National Commission on the Cost of Higher Education, between 1976 and 1996, the average tuition at public 4-year universities increased from $642 to $3,151 (390%), and from $2,881 to $15,581 (440%) at private 4-year universities. In contrast, according to the US General Accounting Office, median household income rose by only 82%. As a result, the portion of a household's income necessary for paying tuition nearly doubled during these years. Here are three key statistics to consider: First, college costs roughly $120,000 for 4 years at a private school and $55,000 at a public school.1 Second, college costs are increasing almost twice as fast as the inflation rate.2 Finally, the odds of winning a full athletic scholarship are less than 1%.3
What is a 529 Savings Plan?
Named after the Internal Revenue Code Section that gave these accounts special tax status, these plans may be one of the best ways to save for your child's education. These specialized investment vehicles allow money to grow over time, and later, qualified withdrawals are exempt from federal income taxes. Qualified withdrawals are defined as tuition, fees, room and board, off-campus housing, books, supplies and equipment (and computers, if the university requires them), provided the child attends an accredited school in the US. Overseas programs qualify if they are likewise coordinated with such a school.
Clearly, the key to affording education expenses is to start saving early. As compared to other education savings plans, a 529 Plan offers a systematic approach to funding and higher permitted maximum contributions: up to $251,000 including assets and earnings, over the life of the account for each beneficiary.* Such plans have gained popularity recently because of enhancements resulting from changes in the revenue code, most significantly the tax-free earnings and maximum contributions permitted.
Why not UGMA/UTMA accounts?
These accounts may not always be the most appropriate option for parents or guardians who want the money to be set aside specifically for education purposes. With an UGMA/UTMA account, the child is the owner of the account, and once he reaches the age of majority, be it 18 or 21, he can use the money for any purpose he chooses. With a 529 Plan, the donor owns the account and controls the money regardless of the age of the beneficiary. Account values may also be transferred to another beneficiary in the family (a sibling, for example) if the first beneficiary does not use it.
What about Education IRA(s)–Coverdell Savings Accounts?
As of January 2002, individuals can contribute to both 529 Plans and Education IRAs. The Economic Growth and Tax Relief Reconciliation Act of 2001 allows contributions to the Education IRA (now called a Coverdell Savings Account) to cover K-12 education expenses on a tax-favored basis. Individuals may benefit by funding a 529 Plan for the child's college and utilizing the Education IRA for elementary and secondary education. There is a significant difference in the maximum contribution amounts between a 529 Plan and a Coverdell Savings Account.
Generally, you (the account holder) may open an account on behalf of nearly any child (the beneficiary), regardless of your income. Grandparents, for example, may save on behalf of grandchildren. You may even put away money for someone who is not a family member. A handful of states open their plans only to their own residents, but most are available to everyone.
Can two people open an account for the same child?
You may open more than one account in a single state for the same child, and more than one person may fund a 529 Plan for the same beneficiary. Regardless of the number of accounts, the state's maximum contribution limit still applies to the beneficiary. States are not required to count balances in out-of-state accounts when determining whether you have met your limit, but some have begun to do so.
How much may be contributed?
A substantial amount: there are high contribution limits in a 529 Savings Plan as compared to other education savings plans. Up to $251,000, including assets and earnings, over the life of the account for each beneficiary may be contributed. Additionally, if you make a contribution of between $11,000 and $55,000 (in 2002) for a beneficiary, you can elect to treat the contribution as though it were made over a 5 calendar-year period. This allows you to utilize as much as $55,000 in annual exclusions to shelter a larger contribution.
What is the nature of each 529 Plan?
There are two general types of 529 Plans: prepaid programs and savings programs. Prepaid programs are offered by some (but not all) states as prepaid tuition contracts covering in-state tuition. Some states will allow you to transfer the value of your contract to private or out-of-state schools, although you may not receive the full value, depending on the particular state. If you decide to use a 529 Plan, the full value of your account may be used at any accredited college or university in the country, as well as some foreign higher learning institutions.
What happens if money in a 529 account is not used for qualified expenses?
It is up to you as a taxpayer to keep a receipt of the expenses for your child or children to make sure that you comply with the intent of this law. For nonqualified distributions, federal law now imposes a 10% penalty on earnings. 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 is disabled (the law is unclear concerning what happens if the beneficiary dies) or if you withdraw funds not needed for college because the beneficiary has received a scholarship. Additionally, the earnings portion of a nonqualified distribution that comes back to you, the account owner, will be subject to tax as ordinary income at your regular tax rate.
What if my child does not go to college?
You may choose to hold the investment in the qualified state tuition program until a later date when the student may decide to attend college, or you may transfer the benefits to another member of the student's family. You may also request a refund, and the account will be refunded according to the program's policy. By federal law, a refund penalty will be assessed, except in the case of the student's death, disability, or receipt of a scholarship.
Who can receive the contributions as the second (or other) beneficiary?
There is a wide list of eligible secondary beneficiary recipients. For the purpose of tax-free rollovers and changes of designated beneficiaries, the designation ?a member of the family? includes the original beneficiary, first cousins, children, grandchildren, parents, grandparents, nieces and nephews, as well as the spouses of each of the above.
How will participating in a qualified state tuition program affect financial aid eligibility?
Any investment is likely to impact a student's eligibility for need-based financial aid. The treatment of investments changes from year to year, making it impossible to know how assets will be treated in the future. In addition, it is uncertain how much or what types of financial aid will be available to families. The College Savings Plans Network is actively working to clarify the federal financial aid treatment of the qualified state tuition programs, but it is a good idea to seek the advice of a specialist for details concerning the effects on financial aid.
What are the gift and estate tax benefits?
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. You should consult your CPA or tax advisor to discuss 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 annual gift tax exclusion (in 2002), so most people can make fairly large contributions without incurring the gift tax.
In addition, the asset leaves your estate but doesn't leave your control. This is an attractive benefit when compared to the “normal” gift and estate tax laws. Individuals interested in reducing estate tax exposure through gift giving but not wanting to give away their assets irrevocably, can now have the best of both scenarios. Of course, if you later revoke the account, its value comes back into your estate. Your estate will also need to include a portion of any contribution made with the 5-year averaging election if you do not live past the fourth year.
Most families tackle higher education in the same way they do other major expenses—in a pay-as-they-go combination of savings, current income, and loans. By saving more money sooner, you can earn interest that can help significantly reduce your family's reliance on borrowing funds or dipping into discretionary income. Clearly, the key to affording this expense is to start saving early, and a 529 Plan may be just the way to go.
Brian A. Sullivan is a Registered Representative with Capital Analysts, Inc., and practicing in Ardmore, Pennsylvania. He has been in the financial service industry for twenty years. Mr. Sullivan may be reached at (610) 658-8600; Sullio@worldnet.att.net
*All assets, including earnings, under all 529 Plan accounts established for the benefit of a particular beneficiary must be aggregated when applying this limit. New contributions will not be allowed once this limit is reached. Earnings, however, will continue to accrue. Consult your tax advisor for how 529 tax treatment would apply to your particular situation.1. The College Board for the 2001-2002 school year (College Board Web site). www.collegeboard.com
2. The College Board, Trends in College Pricing, 2000. (College Board Web site). www.collegeboard.com
3. National Collegiate Athletic Association, Division I Facts and Figures, 2000; NCAA, Division II Facts and Figures, 2001; National Center for Education Statistics, Digest of Education Statistics, 2000. (NCAA Web site) www.ncaa.org