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Investment Planning |
Section 529 College Savings Plans
The 2001 Tax Act has made qualified tuition savings programs even more attractive then they once were, by allowing tax-free withdrawals from the plans to pay for qualified educational expenses. Qualified tuition programs, also known as 529 plans are very beneficial for wealthy and middle-income families.
Section 529 College Savings Plans were established several years ago. Beginning this year, money in a plan account grows tax-free, as long as the money in the plan is used for qualified higher education expenses, including tuition, fees, books, supplies and room and board. Assets in the plan not used for college will be subject to income taxes and the earnings will be subject to a 10 percent penalty, so you may not want to put in more than you know your child will use for college.
Relatives or friends can make annual contributions of up to $11,000 with no tax filing requirements. The plans are a great deal for many people, especially if you are affluent, as it allows you to give large gifts, move assets out of your estate, and provide tax-free growth for the benefit of your heirs.
Advantages of College Savings Plans
Some of the advantages of the plans include:
- Withdrawal of earnings and principal from the plans are tax-free, as long as the money is used for qualified educational expenses. However, under the IRS's sunset provisions, distributions after 2010 are taxable.
- Annual earnings in the account are not taxable.
- Contributions of up to $55,000 per beneficiary may be made in a single year ($110,000 for a couple) without any gift tax implications, although a gift tax return must be filed for gifts over $11,000.
- There are no income limitations for people who make contributions to the plan.
- The donor retains control of the assets, even if the assets are not ultimately used for higher educational expenses.
- Assets can be transferred without a penalty to another family member, including siblings and cousins.
Disadvantages
Some disadvantages of the plans include:
- The investment options are limited to the choices available in the state-sponsored program you choose. Most states have a 529 plan, and California's is called ScholarShare.
- Donors can move money between the investment options within a plan only once per year. For example, if you choose the 100 percent equity option offered by ScholarShare when your child is two years old, and at age 15 decide that you want a more conservative investment, you will be able to reduce your risk by switching options. Currently, there are three ways to switch investments:
- the donor could choose the age-based investment plan, where the investments are riskier (stocks) when a child is very young; as the child approaches college age, bonds automatically are substituted for a portion of the equities;
- the donor could switch from one state's plan to another or between investment options in one state's plan, but the switch can only happen once every 12 months;
- future contributions can be earmarked into a more- or less-risky investment option.
Investment Options
ScholarShare is California's state-sponsored plan managed by TIAA-CREF. If you like another state's plan better than ScholarShare today, you could invest in the other state's plan now, and move the assets to ScholarShare in the future. There are maximum contribution limits, and they vary from state to state.
ScholarShare currently offers four investment options.
- The Age-Based Asset Allocation Option invests in a combination of stock, bond, and money market mutual funds with the percentage of holdings in these investments varying based on the age of the beneficiary. As the child approaches college, the asset allocation is weighted towards fixed income and cash.
- The Equity Option invests in domestic and international stocks.
- The Social Choice Equity Option avoids investing in companies that harm the environment, manufacture weapons, produce alcoholic beverages and tobacco products, produce nuclear energy, or engage in gaming or gambling operations.
- The Guaranteed Option guarantees return of principal and a fixed rate of return.
Impact on Financial Aid and Planning Opportunities
Assets in a 529 plan account are taken into consideration for financial aid if the custodian is the parent or if the student is the account owner. However, the financial planning door opens to two opportunities:
- By making a grandparent, aunt or uncle the custodian, the asset does not come into the financial aid calculation.
- Since beneficiaries can be changed among family members, in households with more than one child and limited income for contributions, contribute to the youngest child's plan first. After the oldest child applies for financial aid and after the financial aid package has been awarded, the income of the student is no longer relevant. The donor can then switch beneficiaries by naming the oldest child. Timing is important and this strategy works best to fund the student's last year of college.
How Does it Compare?
In general, the college savings plan is the best way to get a large amount of assets into a college savings vehicle. The 529 plans also allow a large amount of assets to be moved from a parent or grandparent's estate into a child's estate, to be used for college.
Annual contributions to Educational Savings Accounts (formerly Educational IRAs) are limited to $2,000. This amount is phased out beginning at $95,000 of income ($190,000 per couple). The advantage of Ed Savings Accounts compared to 529 plans is the wealth of available investment options - Ed Savings Accounts can be established at brokerage houses, mutual fund companies, and banks.
With a Uniform Transfers to Minors Act (UTMA) account, you have the advantage of being able to choose your investment options, however there are many drawbacks. First, the UTMA assets become your child's property when he reaches the age of majority . He can use the proceeds for college tuition, a red Porsche, or anything else that he wants. Secondly, the earnings currently are taxed at the parents marginal tax rate under the kiddie tax rules.
The tax-free distribution feature of college savings plans is a giant advantage over accumulating assets in the parent's name, as earnings in the parent's account are taxable. However, assets in the parent's name can be self-directed for asset allocation purposes, and there is no limit to how much can be placed in the account.
Transferring UTMA Accounts to a 529 Plan
Assets in an UTMA account must be sold before being transferred to a college savings plan, as the 529 plans can only accept cash. The minor would be subject to tax on any realized capital gain on the sale, taxable at the minor's tax rate or under the kiddie tax rules. The minor child would remain the owner of the new plan, as UTMA assets were property of the child and must retain their original ownership.
Plan Today
Since there are so many 529 plans available, you'll need to determine which plan is appropriate for you. For more information on the various state plans, check out www.savingforcollege.com. For more information on California's ScholarShare, go to www.ScholarShare.com or call 877-728-4338.
The power of compound earnings works best if you start early. Consider these plans for your children or grandchildren this season and give them a head start on planning for their future.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.