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Battling College Costs: Section 529 Plans

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

The second biggest worry for many investors–after retirement–is how they are ever going to find the bucks to send the kids to college. Whatever is happening in the rest of the economy, inflation certainly is not dead in academia: College costs are accelerating at a nightmarish rate.

You may have heard about the new Education IRA, those puny $500 annual contribution plans. They must have been Congress’s idea of a cruel joke. Most mutual-fund companies won’t even open an account for $500. Even if they would, saving such a tiny sum each year wouldn’t make a real dent in the cost of a college education, anyway. (One source estimates the cost of four years in college will be $191,000 eighteen years from now!)

But a little-known 1997 piece of tax legislation has come to the rescue. Under Section 529 of the tax code, states’ college plans now enjoy tax-deferred growth and estate tax advantages. As a result, more states are starting to offer college savings plans. This new breed of college plan is a major improvement over both the Uniform Gifts to Minors Act and the prepaid tuition plans that had been established by a number of states. (Though Section 529 also grants estate and tax benefits to prepaid plans, they are unlikely to cover the complete cost of tuition.) These state savings plans are a great way for grandparents to help their children and grandchildren, and lower estate taxes at the same time.

A number of states, among them Delaware and New York, have already set up college savings plans, and more have legislation pending–check the College Savings Plan Network for details. Eligibility, schools covered, exemption from state income tax, investment policies, costs, and other important provisions will vary widely, so read the fine print. New Hampshire’s plan is a good benchmark for comparison: Its terms appear to be very liberal, and its investment policy is well thought out.

State-by-state comparisons aren’t only of academic interest. One of the advantages of these wonderfully flexible plans is that you can choose one regardless of where you live and where the recipient of your gift plans to attend school. Further, under the Federal legislation, there are no pesky income restrictions, no age limits, and you don’t even have to be related to the beneficiary. And, remarkably, although a gift invested in one of these plans is treated as a completed gift under estate and gifting tax law (so that donors can deduct their gifts from their taxable estates), the grantor still retains control of the funds. No need to worry about the grandkids blowing it all on an around-the-world motorcycle trip instead.

There is an advantage to making large gifts early if you can afford to do so. In line with the annual gift tax restrictions, you can donate up to $10,000 a year, and your spouse another $10,000. But you may gift five years’ worth at once–up to $50,000, plus another $50,000 from your spouse. (In that case, you’d need to survive for five years for the entire gift to be removed from your estate.) Once an account reaches the maximum $100,505 (a limit that will be adjusted for inflation), no more gifts may be made, but there is no upper limit to the size that the account can grow to. If you gifted $50,000 to an infant, the account might grow enough to provide for undergraduate, graduate, law, and medical school!

As an example of the flexibility of these plans, suppose I live in Florida and my granddaughter lives in Philadelphia. She has it in her mind to go to school in Nebraska, and I want to help her. I can give up to $50,000 to the New Hampshire Fund this year ($100,000 if my wife joins me in the gift). The funds will appreciate tax deferred, and when used by the child for post-secondary-education expenses–including room, board, fees, tuition, and supplies–the money will be taxed at her rate (presumably a low 15%). If she later decides to go to school in Alaska or Hawaii, that’s all right too. And eligible institutions include almost any qualified higher education program including undergraduate, graduate, and accredited trade schools, not just state public schools.

What if she doesn’t go to school at all? I still retain control of the funds, and I can decide to use them to send one of her other relatives to school–and the approved list of just who is a relative is very liberal, including parents, children, and in-laws. As a last resort, if none of her relatives want to attend school, I can take the money back and pay income tax on the appreciation and a 10% penalty tax. (The 10% penalty is waived for death or disability of the beneficiary. If the beneficiary wins a scholarship, then an equal amount can be withdrawn without penalty. )

There is a potentially significant downside: Plan assets must be invested by the states. (This may explain why these plans have been kept such a secret. Stockbrokers, registered representatives, and financial advisors can’t figure out a way to get paid, and so have had little incentive to push them.) Once you pick the plan, you have no investment control. But you can split your accounts among multiple states to diversify. For instance, you can pair New York’s plan, managed by TIAA-CREF, with New Hampshire’s Fidelity-run plan.

In addition, a child who is the beneficiary of such a plan may be less eligible for financial aid. But high-income, high-net-worth families have about the same chance for financial aid as the proverbial snowball down under, anyway. In fact, restrictions are so tight that many middle class families are deluding themselves if they expect their child to get aid. You also may not contribute to an Education IRA in the same year that you contribute to an approved state college funding plan, but in most situations, that’s hardly a sacrifice.

All in all, college savings plans offer a unique combination of tax-favored college funding with estate and gift tax advantages that is hard to beat.