Section 529 College Education Savings Plans

By: Thomas F. Garth

Deep in the Economic Growth and Tax Relief Reconciliation Act of 2001, which is better known for changing the estate tax, is a provision which has great potential for families saving for college. This is the Section 529 College Savings Plans. Section 529 plans were already a good way to save for college. Now they are even better. Under the new tax law, withdrawals for qualified educational expenses will be completely tax-free. Withdrawals for nonqualified expenses will be subject to income tax plus a ten percent penalty. Only cash can be contributed to the plans.
Congress authorized Section 529 Education Savings Plans in 1996. They were designed to complement the already existing pre-paid tuition plans that many states had established. Prepaid tuition plans guarantee that a regular plan of savings will mature to paid college semesters, regardless of the effect of inflation on future college costs. The 529 Education Savings Plans add a degree of risk, because the ultimate value depends on the performance of the investments within the plan. But even with that risk, Section 529 Education Savings Plans have some great advantages over other college-savings techniques.

The Section 529 Plan Advantages.

Section 529 Plans are highly flexible. The money in a Section 529 Education Savings Plan can be used for educational expenses at any accredited school in any state. By contrast, pre-paid tuition plans work best with in-state schools because most plans do not credit a large cash value buildup to these accounts. In Section 529 Plans, assets can easily be transferred among family beneficiaries. If one child does not use the money for college, the person who contributed to the Plan (called the "Participant") can easily designate another child, a cousin, a niece or nephew, themselves, or an unrelated person. Thus, grandparents who set up the plans can switch the money between grandchildren. A Participant could set up his or her own plan and later transfer the assets to his or her child.

Section 529 Plans Offer Control.

If college savings are in Uniform Gifts to Minors Act (UGMA) accounts, parents lose control over the money when the child reaches the age of majority (eighteen in Alabama). The parent may have been saving for Princeton, but the child may choose a Porsche. With a Section 529 Plan, the Participant retains control over the assets until the assets are distributed to pay for education.
Section 529 Plans Have Estate Tax Advantages.
Although most plans will be started with a small initial investment and regular contributions, the law allows one-time gifts of as much as $50,000 to a Section 529 Plan. The Participant can aggregate five (5) years of the allowable $10,000 annual gift tax exclusion to jump start a Section 529 Investment Plan. Wealthy grandparents might consider making a large gift to get cash out of their estate. Even if the grandparents are somewhat worried about needing the money, or that the grandchild will be uninterested in college, the donor retains control over the gift. The donor can take back the gift at any time after paying the income tax plus a federally mandated 10% penalty. This allows a Participant to remove the funds from their estate for estate tax purpose but have access to the cash if later needed.

Section 529 Plans Have Financial Aid Advantages.

Assets in these plans are not considered a student asset in the formulas used to determine financial aid. By contrast, assets held in UGMA custodial accounts are considered student assets and are counted very heavily in the financial aid formula. Until the 2001 legislation, withdrawals from a Section 529 Plan might have been considered income to the student. Now that withdrawals can be made tax free and no 1099 Form is sent out, withdrawals have no effect on a student's assets. Moreover, if the grandparents have established the plan, they need not appear even as a parental asset on the financial aid application form.
Section 529 Plans Have no Limit on Parental Income.
Many other college savings plans either limit the amount of contributions each year or place restrictions on parental income. Section 529 Plans have high limits. A one time $50,000 contribution per donor, and state imposed maximum total contribution limits that range as high as $246,000 (although earnings can grow the account beyond that amount). The Participant does not have to be a parent, grandparent or even a relative. A Participant can make a contribution for any living beneficiary who plans to continue his or her education. If an adult Participant plans to attend law or medical school, he or she can contribute their own savings to a Section 529 Plan. If he or she does not use the money, children can. Also, as a child earns money in summer jobs and after school, that money can be deposited to grow tax free in a Section 529 Plan.
The Alternatives

Section 529 Plans versus Custodial Accounts.

The case for using a Section 529 Plan is so compelling now that many parents may consider closing their custodial (UGMA) accounts, paying taxes on any gains in transferring the cash to a new Section 529 account - where it will all grow tax free (in UGMA accounts, taxes on income or gains are paid at the parent's rate by children under age fourteen, and thereafter at the child's rate.)

If you are considering making a switch to a Section 529 Plan, you must sell the assets in a UGMA account and pay the taxes, because only cash can be invested in the Section 529 Plan. Be aware that Section 529 assets transferred from an UGMA account cannot be used for anyone except the original UGMA beneficiary. You will have more limitations on the funds than you would have in a custodial account. Section 529 Plans require you to spend the tax free money only on a student's tuition, room and board, fees books and supplies. Money taken from a 529 Plan that is spent for other purposes is subject to a 10% penalty. Custodial accounts have a broader definition of allowed expenditure.
Section 529 versus Education IRA
The 2001 tax law expanded the Education IRA annual contribution from $500 to $2,000. It increased the phase-out income limit for joint filers who contribute to such an account from $190,000 to $220,000 ---- double the limit for single filers. Also, the old tax law did not allow students to use the Hope Scholarship Credit or the Lifetime Learning Credit in the same year they withdrew money from an Education IRA. The two credits were created under 1997 tax legislation. The law also now allows you to contribute to an Education IRA and a Section 529 Plan in the same year.
Still, it appears that there may be two advantages to an Education IRA for some families. With an Education IRA, the owner can self-direct the investments, similar to other IRAs. Section 529 Plans are limited to mutual fund accounts offered by the plans. The new law provides that money saved in an Education IRA can be used for private and religious elementary and secondary schools, Section 529 assets can only be used to pay for expenses at an approved institution of higher education.