Some Thoughts on 529 College Savings Plans
 College Savings 529 plans have increased in popularity as states improve their plans to compete in the market place. Tax laws and financial aid rules have increasingly favored them. In response, more parents are using them to save for college. According to the Investment Company Institute, at the end of 2007 there was $129.9 billion invested in 529 plans. Information has prolifered as writers like Joseph F. Hurley, a CPA in Pittsford, New York, publish annual revisions of the book The Best Way to Save For College – A Complete Guide to 529 Plans. Even though a 529 plan is not the one and only perfect solution to funding college, it is one of a number of ways to save and pay for college. 529 plans should be viewed as one building block of an overall strategy, not as the only strategy. This paper will address some of the issues. Prepaid tuition plans are not part of this article.
Tax Incentives
The tax incentives are well known. Earnings are tax-free as long as the monies are spent for certain college costs. In the age of the “kiddie tax” when interest, dividends, and capital gains above $1,800 are taxed at the parent’s marginal rate as long as the student is under the age of 24, parent’s are taking the advice of financial advisors and switching out of custodial accounts.
Thirty-four states allow a deduction or a credit for the contributions to their own plans. A few states such as Maine, Pennsylvania, Arizona, and Kansas allow deductions for contributions to other state’s plans. Unfortunately, Massachusetts is not one of them.
When the earnings are distributed for college, the distribution is tax-free and penalty-free (more on that later).
Annual contributions to a 529 plan are gift-tax free up to the amount of the annual gift tax exclusion which is $12,000 for 2008 and $13,000 for 2009.
The HOPE and Lifetime Learning credits can still be taken for any college expense not paid for by the 529 plan. Parents must be careful to watch out for this potential duplication.
There is no income or asset limitation. A high-income, wealth individual (or couple) can use a 529 plan.
There is no age withdrawal limitation such as the age 30 limitation for Coverdell plans. This means that should children choose not to go to an institution of higher learning
A special election for grandparents needing to lighten up on their estates allows them to gift up to $60,000 ($65,000 in 2009) in one year to a 529 plan for the benefit of a grandchild. If both grandparents can make a $60,000 gift, an estate can be reduced by $120,000 ($130,000 in 2009). None of the gift(s) will be recaptured into an estate of one or both of grandparents, should they live through the five-year period.
Beneficiaries can be changed with tax consequences, permitting flexibility should one or more children decide not to attend an institution of higher learning. Even the parents can be named as beneficiaries.
529 plan accounts can be changed or “rolled over” once a year without any tax consequence.
The limit on the total accumulated contributions to one 529 plan are well over $250,000.
The donor-parent(s) or grandparent(s) retain control over when to distribute, who the beneficiary(s) will be, what mutual fund(s) to use.
Investment Options
529 plans are becoming more competitive in terms of investment options. More plans are offering low-cost index funds as options to actively managed funds. The fees states charge have been lowered. The menu of investment options is wider than it used to be. Age-based options are available in more and more plans.
Asset Protection
In some states, 529 plan accounts are protected from creditors. According to a CFED policy paper researched and written by Barbara Rosen in April 2007, Massachusetts does not appear to be one of them.
There is some federal protection. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 excludes from the property of a bankruptcy estate all contributions made to a 529 plan prior to a two-year period beginning on the date a bankruptcy was filed for a beneficiary who is a child, grandchild, stepchild or step-grandchild of the debtor.
Grandparents will need to carefully consider whether they may need to apply for Medicaid at certain times in the future while still listed as the owner on one or more 529 plans. 529 plan accounts are not protected against the spend-down provisions of Medicaid. If the account has been spent down or otherwise disposed off prior to a five-year lookback period, the 529 plan account monies are probably out of the reach of the Medicaid “clawback” rules. Check with a Medicaid attorney if this is an issue because Medicaid rules change frequently.
Qualified Higher Education Costs (QHEE)
Only tuition, fees, books, supplies, equipment such as computers, and special needs items may be paid penalty-free by distributions from a 529 plan. If a student is at least half-time, room and board can also be paid from 529 plan distributions. The educational institution must be an eligible educational institution, which usually means the institution is eligible to participate in federal financial aid.
QHEE does not include transportation costs, such as airfares, personal expenses, and payments of student loans, even though these are certainly part of the total cost of college.
If a Coverdell Education Savings Account is used to pay for QHEE, 529 plan distributions cannot pay for the same QHEE. The same goes for expenses paid for which either a HOPE of Lifetime Learning credit has or will be taken. Otherwise, a 10% penalty applies, computed on the earnings portion of the distribution.
Overfunding 529 Plans
For most families, overfunding a 529 plan will not be a problem. However, for the wealthy folks and for those lucky few whose 529 accounts have enjoyed immense stock market performance, this can be a problem. Overfunding occurs when there is a balance left in the account after all education expenses, including graduate and doctorial programs, are incurred.
If one or more alternative strategies have been used to fund college expenses, overfunding a 529 plan would not normally occur, unless a child decides not to attend college. Nevertheless, what should be done when it occurs? It is helpful to remember that a parent or grandparent could attend a college or university less than fulltime and if they rename themselves as a beneficiary, the distribution will be tax-free and penalty-free.
Before making contributions, an evaluation should be made as to whether investment performance will outstrip college costs and whether college expenses will be reduced. At the time of this writing (December 2008), these two possiblities seem rather remote, but still need to be looked at, if only for a few minutes.
Alternative strategies such as ROTH IRAs, taxable accounts, and trusts must be considered. Each of these allows a little more control than a 529 plan, both as to ultimate distribution and investment options.
Public or Private
Don’t assume a 529 plan beneficiary will attend a high-priced private college. A conservative way to avoid overfunding is to fund the 529 plans based on the projected cost of a public school education. Costs can be estimated by “googling” for information. One source is the College Board’s annual report “Trends in College Pricing”. Just go to Google and type “Trends in College Pricing”. Even for public schools, there is quite a disparity in pricing.
Will Tuition Be Paid Directly
From an estate and gift tax planning viewpoint, wealthy parents and grandparents can avoid the annual exclusion on gifting, which does apply to 529 plan contributions, by paying for a child or grandchild’s tuition directly to the college or university. If the direct-pay route is a possibility, care must be taken not to overfund the 529 plan. Also, note that only tuition can be paid directly in order to avoid the reporting for gift tax purposes. Room and board, fees, supplies, equipment, and other costs of attendance which exceed the annual gift tax exclusion per child will be subject to the gift tax rules.
Gift Tax Return Filings
A gift tax return must be filed for any year in which the total of gifts from one donor to one donee in one year, including contributions to a 529 plan, exceed the amount of the annual gift tax exclusion. For 2008, that amount is $12,000. For 2009 it’s $13,000. A husband and a wife can each give up to the amount of the annual gift tax exclusion. If both give less than the $24,000, but one spouse gives more than the annual exclusion, then a gift tax return should be filed, claiming the split-gift election. If the special five-year election for giving up to five year’s of 529 plan contributions is made, a gift tax return must be filed because the election is made on the return. Otherwise, part of the lifetime exemption could be used up inadvertently.
Any change in beneficiary to one or more generations below the old beneficiary is potentially a taxable gift. Since most beneficiaries are unmarried children, only the one annual gift tax exclusion would apply. Switching a $100,000 529 plan from a child to a grandchild in one year will result in using part of the lifetime exemption of the account owner, regardless of whether the owner is the child or the parent. If a generation is skipped, the generation skipping transfer tax (GST) may apply. With a $1,000,000 GST exemption, there will be probably be few GST taxes.
Rollovers
Frequently, for various reasons, it may be necessary to switch states or plans within a state. With the onslaught of the bear market, 529 plan owners may be thinking about making changes for investment reasons. These switches are treated as rollovers and they need to qualify under tax rules. A qualifying rollover will not be treated as a distribution for purposes of taxation if there is only one rollover in the previous twelve months. It is not based on tax years. For example, a parent or grandparent cannot rollover a 529 plan account in December and do another rollover in January. However, if the beneficiary is being changed, then the twelve-month limitation period does not apply.
There is also a limitation on changing investment options within the same plan. The IRS issued Notice 2001-55 that said that even though there is no rollover, technically speaking, because there is no switching of plans, a change of options within the same plan can only be done once per calendar year. Unlike the rollover rule which restricts rollovers to one per twelve-month period, this investment strategy change can be done within the twelve month period. Example: a parent changes from the aged investment account to the custom account in December. Then in January, changes the allocation in the custom account. Such a change would be permitted, according to Notice 2001-55. The IRS recognizes that changes in the expected matriculation date for various reasons, or any other such change, may prompt a change in investment strategy.
If a switch is contemplated from a state that has allowed plan deductions or credits to another state, check on the tax consequences of recapture of previously allowed deductions or credits.
Qualified Beneficiary Changes
To be a qualified beneficiary change, only a change to certain members of the family can be made. A change to any other member will be treated as a disqualified change and the distribution will be subject to regular income tax and the 10% penalty on the earnings.
The following are defined in Internal Revenue Code 529 as members of the family:
♦ son or daughter or a descendant of either
♦ stepson or stepdaughter
♦ a sibling, stepbrother or stepsister
♦ father or mother or ancestor of either
♦ stepfather or stepmother
♦ cousin
♦ son or daughter of a brother or a sister (nieces and nephews)
♦ brother or sister of the father or mother (aunts and uncles)
♦ son-in-law, dauther-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law
♦ spouse of the designated beneficiary or the spouse of any individual described in above items
Changing accounts to a member of the family who is one or more generations removed may result in gift tax consequences. See the section above on Gift Tax Return Filings.
Financial Aid Considerations
Financial aid comes from at least two main sources: the federal government and the college or university. In order to qualify for aid, the student must file a Free Application for Federal Student Aid form (FAFSA). 529 plans are treated as assets of the parent, not the child. Therefore they are only “assessed” the 5.6% rate that applies to assets owned by the parents.
Even if the student is named as the account owner, the 529 plan will still be considered as the parent’s asset.
Important planning point: If grandparents are the account owners, the 529 plan is excluded from the FAFSA. Hint for you parents: stay on the good side of your parents! They may be able to lower your expected family contribution for college.
When selecting asset and/or investment strategies, keep in mind that certain accounts are treated differently for financial aid purposes. A UTMA custodial account will be treated as the student’s asset and assessed at 35%. In other words, the government and the college or university is saying the student needs to spend that money for college. Otherwise, any potential aid package will be reduced by 35%.
Coverdell Education Savings Accounts are also counted as the student’s assets.
ROTH IRAs (and all retirement accounts) are excluded from the assets of both the student and the parent when completing the FAFSA form. The earnings of a ROTH IRA are tax-free if left in the account for at least five years starting from the date of the first contribution or until age 59 ½. The contributions themselves can always be withdrawn, but the withdrawal will be counted as a resource in the financial aid formula. ROTHs are worth consideration as one of several strategies used simultaneously in saving for college.
Standard brokerage accounts in the name(s) of parents are counted as assets of the parents, not the student. These taxable accounts allow for maximum flexibility in investment strategy, avoid fees of 529 plans and Coverdell accounts, and leave control in the hands of the parents.
Trusts are generally treated as the asset of the child.
Where to Find The Best 529 Plans
A financial advisor with Morningstar Advisor Workstation Office Edition can scope out the best 529 plans. Every year, Morningstar analysts comb through the 529 plans and chose the best, the worst, the improving, and the defunct. The best were published in the Summer 2008 edition of Morningstar Advisor, an exclusive publication for advisors. These are as follows, listed alphabetically, not according to rank:
Alaska T. Rowe Price College Savings Plan●
Colorado Scholars Choice College Savings Program*
Illinois Bright Start College Savings Program
Kansas Learning Quest Advisor*
Maryland College Investment Plan●
Michigan Education Savings Plan
Nebraska College Savings
Nevada Vanguard 529 College Savings Plan*
South Dakota College Access 529
Utah Educational Savings
Virginia CollegeAmerica*
Virginia Education Savings Trust
Plans with an * asterisk after them are sold only through brokers. The two plans with the ● asterisk after are sold only direct. The others are sold both direct and through brokers.
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