529 College Savings Accounts - What's Their Angle?
A 529 college savings plan is similar to a Roth IRA: It is a savings account to which after-tax contributions are made; earnings and "qualified" withdrawals are free of federal income tax. Under a 529 savings plan, an individual account owner (typically, a parent or grandparent) makes after-tax contributions to the plan to fund "qualified" higher education expenses for a named beneficiary. There are no income limits or age restrictions on who can invest in the plan. Currently, all contributions must be made in cash. Further, most plans allow investments of at least $100,000 per beneficiary, although this varies from state to state. Contributions are eligible for the annual gift tax exclusion, and in most cases, the accounts are excluded from the estate of the account owners.
The plan's investments are selected by the state, generally with assistance from a mutual fund company or other provider that acts as a professional investment manager on behalf of the state. Although the account owner cannot control the investment management of the plan, most plans allow the account owner to select among different investment strategies provided by the plan. Most plans provide an agebased asset allocation portfolio and a fixed asset allocation portfolio. Also, many plans allow account owners to reallocate their funds to different investment categories once a year. The ultimate amount available to the beneficiary for higher education costs depends upon the performance of the investments, although some plans guarantee a minimum rate of return. Because they are state-sponsored plans, many 529 plans allow a state income tax deduction for part or all of the money contributed. However, at the time this article was written, no state permitted residents who invested in out-of-state plans to deduct the amount of contributions. Many states exempt earnings generated from instate plans from state income taxes, and a few states provide a state income tax exemption for earnings to residents who invest in other states' plans. Many states exempt withdrawals from plans of any state. A few states match part of the contributions, subject to income and other restrictions. Further, some states offer scholarships for students with state 529 plans who attend in-state schools. Many states no longer require proceeds to be used at in-state public schools. Proceeds may be used at accredited private schools or out-of-state public or private schools, although penalties may apply. FEDERAL TAX CHANGES EFFECTIVE 2002 EGTRRA made several favorable tax changes to 529 plans, effective January 1, 2002 adding to their appeal. Highlights include: * Tax-free earnings accumulation and withdrawals. Starting January 1, 2002, earnings accumulation and withdrawals for "qualified" higher education expenses are free from federal tax. Under prior law, the beneficiary was required to pay income taxes on the accumulated earnings upon withdrawal. Increased rollover ability. Rollovers between 529 plans of different states (or the same state) for the same beneficiary are permitted once every 12 months. Prior to this change, a rollover was permitted only to change the beneficiary to another family member. The increased rollover ability makes college savings assets more portable and increases flexibility in selecting among program providers and investments. For example, if the account owner were dissatisfied with the investment performance of a current plan, the account owner could change the provider or investment mix of the savings plan by rolling over the account to another state plan, thus retaining some degree of control over the investments of the plan. * Coordination with education IRAs and Hope Learning credit. Excise taxes are no longer imposed on combined contributions to education IRAs and 529 plans for the same beneficiary. But distributions are coordinated for 529 plans, education IRAs and the Hope and Lifetime Learning credits. * Penalty on nonqualified distributions. Although not necessarily good news, the same 10% federal additional tax on accumulated investment earnings that applies to nonqualified withdrawals from education IRAs is extended to 529 plans (exclusions for certain withdrawals, such as disability, death, receipt of scholarship continue). EGTRRA does, however, eliminate the requirement that the state impose a penalty. * Removal of dollar limit on qualified room and board expenses. There are no dollar limits on "qualified" room and board expenses, as under prior law. Instead, an educational institution is permitted to determine the appropriate dollar amounts for students living at home, living off campus and for those living on campus. |