Read an Excerpt
The Basics to Opening a College Saving Account
Excerpted from 529 College Plan Made Simple by Richard A. Feigenbaum and David J. Morton ©2005
Establishing a College Savings Account is as simple as completing an application with one of the Plan Managers. Completing the application and getting started is relatively simple. Much like any financial investment, there are many different choices available for investing the assets. You must give thought to the duration, risk tolerance, and available investment options within the College Savings Account before you settle on an investment strategy.
Rules, Rules, Rules
The law is clear as to what is required of each state and of the consumer to achieve the benefits of tax-free growth on investments. To qualify for special tax treatment, federal tax law requires that the account must meet the following basic requirements.
• The account must be created under a state's 529 Plan.
• The account may only receive cash contributions-no stocks, securities, or other business interests.
• No one-whether the owner, contributor, or beneficiary of the account-can have investment control over the account. Only the state-or its delegated investment firm-may direct the investments.
• Only certain maximum levels of funding are allowed.
• The College Savings Account cannot be pledged as collateral or security.
• The program, as administered by the states, must provide a separate accounting for each beneficiary of a plan.
• The College Savings Account must be used for qualified higher education expenses.
• The College Savings Account funds must be used at an eligible educational institution to have all gains and appreciation be tax-free at the time of distribution.
The Account must be Created Under a State's 529 Plan
By requiring each state to adopt its own plan (rather than a uniform national plan), each state can tailor and modify the plan as it sees fit. This will allow for changes and improvements as the years go on. While the industry is still in its infancy, differences among the states have started to occur and changes are being adopted on a frequent basis. Understanding the differences among these state plans, when coupled with the many investment options and the returns on the account assets, can help a well-informed consumer select the appropriate College Savings Account. It can also confuse the consumer who, without a professional advisor, may wander aimlessly among the options. This may result in an inability to even get started opening an account.
Differences Among the Plans
Some College Savings Accounts are only available to those who reside in the state. Some plans are available to non-residents, but only through a broker-who typically will charge a sales commission or an annual fee during the period of time the assets are invested in the plan.
Each state has its own rules about whether a resident investing in his or her state's plan gets a special income tax deduction. In addition, each state has its own rules about whether the withdrawal of funds from an account will be income tax-free or taxable at the time of withdrawal.
Some plans have enrollment fees, an annual account maintenance fee, asset-based management fees, and an underlying fund expense. These fees are often in addition to that which is paid to the advisor assisting in the opening of the College Savings Account.
There are also differences stemming from the choice of investment options (or lack of options). Some plans have investment choices based on the consumer's preference or tolerance for risk (e.g., growth, balanced, aggressive growth, bond fund) and exposure to the marketplace. To gain a competitive edge, the Plan Managers continue to increase the consumer's options in an effort to give them some measure of control over the selection of investments.
The Account may only Receive Cash Contributions
Under the law creating College Savings Plans, it is absolutely clear that only cash can be used to open or contribute to a College Savings Plan. This seemingly innocent requirement does create an issue for those who have been saving for college for some time now. For many years, the traditional approach to saving for college has been to utilize an account titled in the child's name under the Uniform Gift to Minors Act (UGMA) or its more modern relative, the Uniform Transfers to Minors Act (UTMA).
Governed by individual state's laws, these UGMA/UTMA savings accounts are taxable investment accounts, with all taxable income taxed to the child. Under these kiddie tax laws, income and capital gains of a child under 14 are taxable to the parents, and after age
14, are taxable to the child. Certainly, those with existing accounts will seek a way to transfer the existing account into a College Savings Account.
Unfortunately, the UGMA/UTMA account is normally not invested in cash, and would require that all the investments in the account be sold and converted to cash before the money could be transferred to a College Savings Plan. This liquidation would result in taxable income if the account had appreciated (gone up) in value.
You cannot have Investment Control Over the Account
Only the state or its Plan Manager (the designated investment firm) may direct the actual investments of the account, while the owner, contributor, or beneficiary of the account cannot. For the consumer, this means that there is a loss of control over the investing of assets. For many, this may be the best possible thing. For others, it will create a frustration over seemingly lost opportunities.
To provide more flexibility to the consumer without violating this mandate, the Plan Managers have begun offering more than just age-based investment options. Many Plan Managers now allow for risk-adjusted options within these age-based approaches.
When a College Savings Account is opened, the person who opens the account is very often labeled the owner. The owner is the person who has the ability to name the beneficiary, change the beneficiary from time to time, and withdraw funds from the account. While being prohibited from having direct control over investments, the account owner can gain some measure of control by searching for a Plan Manager that provides the options that meet with the account owner's liking.
Given that the many Plan Managers will each have their own selection of funds and alternative investment options, account owners may look for opportunities to chase the best return in the marketplace. (Chase means to try to time the market by jumping in and out of investments.) To prevent an account owner from gaining control (indirectly) of the investments by shifting from one Plan Manager to another, the law prohibits the transfer of an account more than once per year.
Only Certain Maximum Levels of Funding are Allowed
Remember, these plans are designed for the purpose of saving for college. Parents can save for children; grandparents for grandchildren; charities can save for scholarships; aunts, uncles-everyone can save for everyone, but not too much. Even as expensive as college is, there is a limit. The law only allows for the saving of money for qualified higher education expenses. Since the law allows each state to implement its own sets of rules, this is one area that will vary from state to state. As you compare state-by-state plans, you can see differences in the maximum funding level.
For instance, in 2003 in the state of Rhode Island, the maximum funding level was $301,550, while in New Hampshire the maximum was $250,000. Most states are close in total maximum funding, being somewhere in the $250,000 to $300,00 range. In reviewing the participation handbooks for the various Plan Managers, you can determine the rationale for that particular state. The way it is supposed to be done (as provided by regulations) is by determining the estimated cost of tuition, fees, and room and board of a student attending five years of undergraduate school at the most expensive school in the state. So you can see that on a state-by-state basis, this amount should not vary much.
The value of fully funding a College Savings Account goes beyond the ability to adequately provide for a child's college education. As a wealth transfer tool, the fully-funded 529 Plan can create substantial estate tax, gift tax, and generation-skipping transfer tax savings for families of wealth.
The College Savings Account cannot be Pledged as Collateral or Security
As a society, we tend to borrow too much, too often. However, the law makes it clear that the 529 Account is not allowed to be used as collateral for a loan or other debt. You cannot pledge or borrow against the 529 Plan. This means that the money really will be used for college unless the money is withdrawn. In that case, there would be a disqualifying distribution.
By preventing the account owner from borrowing against or pledging the College Savings Account for his or her loans or debts, these assets will truly be hands-off, and the assets will grow for college expenses. This puts the consumer in a position of either finding other sources for short-term borrowing or completely withdrawing assets from the College Savings Plan and incurring both the income tax and a 10% penalty on the income withdrawn. Congress' intention was to make this disqualifying distribution a costly exercise to act as a deterrent from short-term borrowing.
The Program must Provide a Separate Accounting for Each Beneficiary of a Plan
It seems obvious, but the law makes it clear nonetheless-a Plan Manager must provide a statement of each beneficiary's account, providing the following details (at least annually):
• contributions during the accounting period;
• account value;
• earnings; and,
Most Plan Managers send a quarterly account statement. The law provides that if the Plan Manager does not send a statement at least annually, they must make the information available upon your request.
The College Savings Account must be Used for Qualified Higher Education Expenses
To get the tax-free investment gains in the 529 Plan at the time of distribution, it is clear that the funds must be for qualified higher education expenses. If some or all of the distribution is not used for these qualified expenses, the owner of the account will have to report the portion of the withdrawal that is a gain or profit on his or her tax return. This gain or profit must then be placed on the account owner's tax return and taxed as ordinary income.
In addition, there is a 10% penalty tax on the income or gains earned. This penalty acts as a true deterrent for using these assets for anything other than qualified higher education expenses. The basic premise to the plan is that the money saved in this tax-favored savings account is intended to be used to pay for college and college-related expenses. (Since the law was first enacted in 1996, the definition of qualified higher education expenses has been expanded to include more of what a family would typically expect these expenses to be.)
As amended by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Section 529 Plan distributions, including all investment gains and profits,
will be completely free of any tax at the time the money is used if it is withdrawn for one or more of the following:
• room and board (if the student is enrolled at least half-time);
• equipment required for enrollment; or,
• for special needs children-expenses incurred in connection with the child's enrollment or attendance at an eligible school. (Congress has not yet defined the term special needs.)
The College Savings Account Funds must be Used at an Eligible Educational Institution
Remember that even though the funds in the 529 Plan need to be used for qualified expenses, they must also be used at an eligible educational institution. The law defines the term eligible education institution by means of reference to the Higher Education Act of 1965. A simpler definition is that any accredited college, graduate, or post-secondary, trade, or vocational school that can participate in the federal student aid program will qualify. Specific information about a college or university can be found at the following website: www.ed.gov/offices/OSFAP/Students/apply/search.html.
It is absolutely imperative that you verify that the school is accredited and eligible under this definition. You can find out by contacting the school directly or by asking the Plan Manager sponsoring the plan in the state in which the school is located. If the school is not accredited and therefore not eligible, then any distributions from a College Savings Account will be fully taxed to the owner of the account and will be subject to the additional 10% penalty.
Future Changes in the Law
Changes to the law are made on a frequent basis-both to the Internal Revenue Code Section and to any regulations. One item to keep track of is the possibility that the
College Savings Plan and its law may sunset (come to an end) on December 31, 2010. The sunset provision requires additional legislation to keep the College Savings Plan law on the books. Were the law to sunset without any changes being implemented, then many of the following will expire on that date:
• tax-free distributions of earnings;
• the ability to rollover plan assets without a change of beneficiary;
• the addition of first cousin as a member of the family;
• the ability to contribute to a Coverdell Savings Account in the same year as a contribution is made to a College Savings Account;
• rules about applicability of the College Savings Plan to special needs individuals; and,
• the coordination with Hope Scholarships and Lifetime Learning Credits.
While it is unlikely, it is possible that the law will sunset on December 31, 2010. It is unlikely, as recent estimates put the value of College Savings Accounts at approximately $100 billion by the end of this decade. This will represent a substantial portion of the population that is saving funds for college. For this reason, Congress will be hard pressed to reverse the favorable tax benefits given these College Savings Accounts. Nonetheless, if these accounts were no longer to be treated with these favorable tax benefits, then any withdrawal from the accounts, whether used for qualified higher education expenses or not, would be subject to ordinary income tax and possibly the penalty tax of 10%.