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Combine Investment And Tax Benefits In 529 Plans

With college costs continuing to soar, what’s a cash-strapped parent to do? Consider the benefits of a Section 529 plan. This vehicle can provide tax-advantaged earnings for multiple students in your family without adverse gift tax complications. Anyone, including a student’s grandparent, can set up a 529 plan.

Each state offers one or more 529 plans, encouraging families to set aside funds for future education expenses. The states also set contribution limits for the plan, but at $300,000 and more, that’s rarely an issue for parents or grandparents interested in funding a 529. As long as you meet a few rules, an investment in a 529 will grow without being eroded by taxes on account earnings. And distributions to pay for qualified college expenses—including tuition, fees, books, supplies, equipment, and room and board for full-time students—are tax-free.

There are two main types of 529 plans:


1. Prepaid tuition plans. This type of 529 is all about keeping pace with inflation in education costs. Suppose it currently costs $25,000 a year to send a child to a state university. You can pay $25,000 right now to buy shares in one of your state’s prepaid 529 plans. If, for example, the beneficiary is an eight-year-old, when the child is ready to go to college in 10 years, your shares will pay for an entire year of tuition—no matter what it costs at that point.


This type of plan is often attractive to parents because it offers peace of mind. And, because tuition costs have been increasing much faster than overall inflation, the return on your investment is likely to be pretty good—much better than you’d get with the safest alternatives, such as U.S. Treasury bonds or certificates of deposit. Because the state guarantees your investment, there’s no risk you’ll lose your principal. One disadvantage of prepaid plans, however, is that they lock your child into attending one of your state’s public universities.

2. College savings plans. In contrast to a prepaid tuition plan, with college savings plans there’s no guarantee that the growth in your assets will keep pace with increases in college costs. But there’s a bigger upside potential with this kind of plan, because you direct how the money is invested and you potentially could earn a better return than you’d get with a prepaid plan.

Most 529 college savings plans offer an asset allocation strategy geared to a child’s current age or the year that child will enter college. Typically, that means there’s a more aggressive mix of investments in the early years, with the allocation becoming more conservative as college entry draws near. But 529s often also offer other options that give you more control of how assets are invested.

Though 529 plans are state sponsored, you don’t have to use one from your state. But more than half of the states give residents state tax deductions for contributions, and there may be other incentives for staying in-state.

There are additional advantages to saving for college with a 529 plan. If there’s money left in an account when one child is finishing school, you can switch that plan’s beneficiary designation to a younger son or daughter. Typically, plans allow one such change a year. You also can change the beneficiary if one child decides not to attend college.

This ability to switch beneficiaries also means that the benefits of a 529 could continue indefinitely, thereby helping grandchildren or other family members. You also can cash out of a plan after the beneficiary graduates, though you’ll owe tax on any leftover earnings.

A 529 plan also may avoid gift tax traps. Normally, you can make gifts to anyone of up to the annual gift tax exclusion ($14,000 in 2015) for each recipient without owing gift tax. That exclusion is doubled to $28,000 for joint gifts by a married couple. But the tax law also allows you to contribute an amount equal to five years of gifts to a Section 529 plan in one year. So you can transfer up to $70,000 all at once (or as much as $140,000 if you’re giving as a couple) to an account for one beneficiary, completely free of gift tax.

If you’re contributing to a grandchild’s account, you also must consider the implications of the generation-skipping tax (GST). However, the tax law allows a generous exemption of $5.43 million in 2015 that is indexed for inflation and will be higher in future years. That can help grandparents shield 529 transfers from the GST tax.

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