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Section 529 Plans Keep Getting Better And Better

For parents saving for their children's college education, a Section 529 plan may offer several advantages.  Now a new tax law—the Protecting Americans from Tax Hikes (PATH) Act of 2015—enhances those potential 529 benefits.

Section 529 plans, operated by individual states, let families set aside money to cover future education expenses of account beneficiaries.  If certain requirements are met, investments in the plan grow without being eroded by current taxes, and distributions to pay "qualified" expenses—which include tuition, fees, books, supplies, equipment, and room and board for full-time students—also aren't taxed.

Now the PATH Act permanently extends a rule treating computers and related equipment as qualifying college expenses.  This provision had expired after 2014, but was restored retroactive to 2015 and made permanent

There are two main types of 529s: prepaid tuition plans and college savings plans. 

1.  Prepaid tuition plans.  This type of plan is designed to keep pace with the rising cost of college tuition.  Suppose it currently costs $25,000 a year to send a child to a state university.  You can spend $25,000 now to buy shares in the plan for an eight-year-old.  When the child is ready to go to college in 10 years, the shares you bought will pay for an entire year of tuition—no matter what it costs at that point.  (You don't have to make a single big initial deposit to a prepaid plan. Later contributions will be credited according to the costs that prevail at the time.)

A prepaid tuition plan ensures that the money you put in will grow to keep up with rising costs.  And returns tend to be far higher than those on most conservative investments.  You don't risk losing your principal, and your investment generally is guaranteed by the state.

2.  College savings plans.  In contrast to a prepaid tuition plan, a college savings plan doesn't guarantee that your returns will keep pace with rising college costs.  But these plans have the potential to produce higher returns than a prepaid plan depending on the performance of the investments you choose.

Usually, these 529s offer an asset allocation strategy geared to the current age of beneficiaries or the year when they'll enter school.  Such strategies may use more aggressive investments in the early years and switch to more conservative options later.

You're not obligated to use a Section 529 college savings plan for a college in your state, and you're free to use another state's plan if you like its features.  Keep in mind, though, that in-state plans may offer state income tax deductions or other benefits for residents.

These plans also offer flexibility if an intended beneficiary doesn't go to college or if there's money left over after graduation.  In either case, you can switch to a different beneficiary.  Typically, a plan will allow one such change a year.

The PATH Act includes a couple of other significant changes in this area.  For one thing, it adjusts a rule relating to taxable distributions for non-qualified expenses.  Under the new law, each such distribution will be taxable based on the amount only in that particular account, rather than in all the Section 529 accounts you've established.  In addition, if a Section 529 plan distribution is used to pay for tuition and subsequently is refunded—for example, if your child leaves school—the new law permits you to contribute that amount to another 529 plan within 60 days.

Finally, a Section 529 plan also offers gift-tax advantages.  Normally, you can give anyone up to a specified amount—$14,000 in 2016—without owing gift tax.  That amount is doubled to $28,000 for joint gifts from a married couple.  But with 529s, you can contribute an amount equal to five years' worth of gifts if a proper gift tax return is filed.  That means you could put $70,000 in an account for one beneficiary—or $140,000 if you give with your spouse—completely free of gift tax.




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