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Section 529 Plans Are Popular But Not The Only Way To Go

Section 529 plans are a popular and tax-efficient savings vehicle for college funding.  529 plans are state-sponsored programs although private education institutions can establish their own plans.  Although these plans are state-sponsored, students are not limited to attending state schools.  Any accredited college or university qualifies.  These plans come in two types: prepaid tuition also known as guaranteed savings plans and investment plans.

529 plans have limited investment options (each state makes available only a few investment options).  However, the income tax breaks are extremely enticing.  Investment monies grow tax-deferred and, as long as the beneficiary/student utilizes these monies for higher education costs (such as tuition, books, room and board), the earnings are tax-free from a federal tax standpoint.  If a resident is from the state offering the plan, earnings are typically state income tax-free as well. 

The owner (many times, a parent although it can be the child or another interested party) retains full control of the account.  Under Uniform Transfers to Minors Act (UTMA) or Uniform Gifts to Minors Act (UGMA) accounts (which are popular methods to fund educations in their own right), ownership of the account balance goes to that specified child at their age of majority which is typically age 18 or 21  (Pennsylvania is 21) depending upon the state you live in.  The 529 plan owner is in control and determines when withdrawals can be taken.  Owners can change beneficiaries and excess funds can be used for younger siblings and/or other beneficiaries.

Each state except Washington offers at least one 529 plan, but families are not strictly limited to their state’s plan or the plan of the state where a student attends college.  Because of the different features, careful analysis is critical.  In the case of a prepaid tuition plan, either the owner or the beneficiary needs to be a resident of the sponsoring state.

There are no eligibility requirements to open a 529 plan.

There are a few considerations to be made before investing in 529 plans.  The first is that 529 plans will probably impact financial aid eligibility.  A 529 investment plan will be looked at as if it is an asset of the parent or other account owner if not the child’s when it comes time to determine eligibility for federal financial aid.  Although this will still be a negative, it is much more reasonable than the penalty taken against assets if it were an asset owned by the child in a custodial account for the child.  Any payments made from a prepaid program are treated as an additional resource and would reduce financial aid on a dollar-for-dollar basis.

There is also a federal penalty to be aware of for non-qualified withdrawals.  For each non-qualified distribution (a withdrawal not used for an approved expense), a 10% penalty is incurred on earnings and those earnings are taxed at ordinary income tax rates.  This penalty is not incurred if the account is terminated because the beneficiary has passed away or is disabled.  The penalty is also waived dollar-for-dollar if the beneficiary receives a scholarship up to the total value of the scholarship.  However, earnings will still be taxed. 

In addition to utilizing 529 plans to fund educations at universities and colleges, there are other excellent education savings vehicles including Coverdell education savings accounts and UTMA/UGMA accounts that also have their own unique set of benefits.  These types of accounts offer maximum investment flexibility whereas 529 plans do not.  Furthermore, with UTMA/UGMA accounts and Coverdells, their proceeds can be used for private schools for grades K through 12.  Although 529 plans may appear to be the best option from a tax standpoint, most times, utilizing them in conjunction with these other educational savings vehicles is often the best solution.


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