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An Update On College Savings Plans

Section 529 college savings plans offer parents and grandparents the opportunity to save for college or prepay a child’s tuition and fees—and now they’re an even better deal. A 2006 law made the tax break for distributions permanent—it had been scheduled to expire after 2010—and new rules improve the financial aid prospects of student beneficiaries of 529s.

There are two basic types of 529 plans. One lets you save for college by investing in a state-administered account. There may be several investment options with varying blends of risk and potential reward. When the account beneficiary heads to college, you withdraw money from the account to pay qualified educational expenses. A second type of 529 lets you prepay a child’s future tuition at today’s rates.

Prepaid 529s themselves come in two varieties: State-run traditional prepaid accounts, which cover tuition and fees only at state schools (though you can generally transfer the value of your contract to out-of-state or private colleges), and Independent 529 accounts, which can be used to pay tuition at hundreds of participating private schools. Both types of prepaid accounts let you purchase a tuition credit.

Suppose you open a prepaid account for your newborn grandchild in 2009, and contribute $15,000, which is half of what tuition costs this year at the college your grandchild will eventually attend. When you use the credit, 18 years down the road, it will cover half a year’s tuition, even though by then that may cost four times what it does today.

One major perk of both kinds of 529s is that they are usually exempt from federal income tax, and in some states you can receive an income-tax deduction. Neither earnings on 529 investments nor withdrawals to pay college expenses are subject to capital gains or income tax. The same is true of prepaid plans.

Another 529 benefit is that the money you contribute reduces the size of your taxable estate. You and your spouse can both use your $13,000 annual gift tax exclusions to build the account, and 529’s also offer the chance to lump five year’s contributions in a single year. That means a married couple could jump-start a child’s or grandchild’s plan with $130,000. Moreover, you can do that for as many beneficiaries as you like.

If your student opts against going to a school covered by a prepaid plan or simply chooses not to go to college, you, as owner of the account, can probably change the beneficiary to someone else in the family. That should avoid the adverse tax consequences of simply taking back your money, which will cost you a 10% penalty, income tax on account earnings (though not on the principal contributed), and additional state taxes if you received a state tax deduction for your contribution. However, if the account beneficiary has died or is disabled or receives a scholarship, you can probably avoid the 10% penalty.

While a 529 savings account can be used at any accredited school, and the money covers tuition, room, board, books and supplies, there’s no guarantee it won’t lose money or fail to keep up with inflation in college costs. In contrast, a prepaid account guarantees a future tuition rate, but in addition to a limited list of participating schools—and a likely loss in value if you transfer your contract to an outside college—the money can go only to pay undergraduate tuition and fees.

You could also combine the plans. Assume, for example, that private school tuition will increase 8% per year, the historical average according to the College Board. By allowing you to prepay tuition, a 529 prepaid account effectively guarantees that return, and could be treated as the cash or bonds portion of a college savings portfolio. A 529 savings account, invested mostly in stocks, could provide greater potential growth.

A final consideration when funding a 529 plan, particularly if it will benefit a grandchild who might qualify for financial assistance, is how 529 account funds are handled in the federal financial aid formula. Recent rule changes mean prepaid plans are now treated the same as savings plans; both are considered parental assets. As a result, just 5.6% of the account balance is factored in each year to determine how much a family can afford to pay. And now money in custodial plans converted to 529s also counts as parental assets—instead of belonging to the student and being tapped at a far higher rate.

Section 529 plans are not suitable for all investors, and this article is not a recommendation to purchase or sell one of these securities, which can be made by prospectus only. Section 529 plans are not guaranteed and you can lose money. Some Section 529 plans offer state tax benefits depending on your state of residence. Check on available state tax benefits before investing.


This article was written by a professional financial journalist for Legend Financial Advisors, Inc. and is not intended as legal or investment advice.

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