are many ways to save for college, but one thing is certain: it is never
too early to start. One relatively new way to save for college is a qualified
tuition program (QTP), or "Section 529" plan. These plans offer a way
to pay for college expenses with some nice tax advantages. The 2001
Tax Act expanded the benefits of these plans.
What are they?
tuition plans allow you to set up a tax-advantaged account for your
child's college education. There are two types of Section 529 plans:
prepaid tuition programs and college savings plans.
tuition programs let you lock in today's tuition costs
by purchasing tuition credits or certificates that a student redeems
when he starts college. Prior law limited these plans to state-run
plans. However, The 2001 Tax Relief Act permits education
institutions to establish and maintain prepaid tuition plans beginning
savings plans let you make contributions to a state-sponsored
savings account to build a fund for your child's college expenses.
These accounts are generally managed by a private mutual fund
How do they work?
a gift to set up an account. You start by setting up a
qualified tuition plan account and naming your child (or anyone
else) as the beneficiary. Your contribution is considered a gift.
Your contributions qualify for the $11,000 annual tax-free gift
exclusion ($22,000 for married couples making a joint gift).
Special rules for 529 plans let you average your gift over five
years. This means married couples can make a $110,000 joint gift
and individuals can make a $55,000 gift in a single year, without
incurring gift tax. However, you cannot make additional gifts
to your child for five years, or you may owe gift tax.
contribution is limited. You aren't permitted to make
contributions to a 529 plan beyond what is necessary to pay for
your child's college expenses. Each plan sets its own limit. Generally,
your contributions to a prepaid tuition program will be limited
to the number of credit hours that it takes to obtain a degree.
Savings plans usually limit your contributions to the estimated
cost to attend the colleges eligible under that state's plan.
Most plans allow you to make either a lump sum contribution or
a series of monthly contributions. All contributions must be made
in cash; you can't contribute shares of stock or other property
to these plans.
remain in control. You cannot choose the investments in
the fund — a fund manager does this. However, you do remain
in charge of all withdrawal decisions. You can allow your child
to make withdrawals to pay for college expenses. If your plan
permits it, you can change the beneficiary to another family member
without losing the tax benefits. If you change your mind about
maintaining the account, you can even request a refund (tax and
penalties will apply).
Other types of accounts, such as education savings accounts (previously
called education IRAs) and custodial accounts, don't offer this
control. Once you set up these accounts, your child is the legal
owner. As long as your child is a minor, you may control the investment
and withdrawal decisions. However, in most cases your child can
withdraw funds, for any purpose, when he or she reaches legal
age (18 or 21 in most states).
child can withdraw money to pay for college expenses.
Section 529 funds must be used for qualified higher education
expenses, such as tuition, fees, books, and supplies. They can
also be used to cover certain room and board expenses, as long
as your child attends school at least half-time. If your child
receives a scholarship, you can request a penalty-free refund
up to the amount of the scholarship. In addition, you can withdraw
the funds if your child becomes disabled or dies.
If the funds are withdrawn for any other purpose, you (not your
child) pay tax on the earnings that have accumulated in the fund.
The new law repealed the required plan-imposed penalty and replaced
it with a 10% excise tax. However, your plan may still charge
can change plans. Prior law allowed a tax-free and penalty-free
rollover from a QTP for your child to a QTP for another family
member. Now you can make a tax-free rollover to another plan with
the same beneficiary. That allows you to move your child's plan
to another state's plan or to change your child's state-run plan
to one run by a private institution without losing the tax benefits.
This tax-free rollover treatment only applies to one transfer
within any 12-month period.
are the benefits?
are the disadvantages?
plans offer an attractive alternative to other college funding plans,
they are not without drawbacks. There are a number of factors you should
consider before you invest in a qualified tuition plan.
penalties apply to nonqualified withdrawals. What if
there are funds left in the account after your child completes
his college education? What if you change your mind about sending
your child to college? What if an emergency arises, and you need
the funds for yourself? You may request a refund, and the account
will be refunded according to your plan's policy. However, any
nonqualified distributions will be subject to withdrawal fees
and penalties. You'll also owe income tax on the distribution.
out for the GST trap. Generally, changing beneficiaries
to another member of the family doesn't trigger tax. However,
when you change a beneficiary to a family member that is a generation
below that beneficiary, the generation-skipping tax (GST) will
apply. For example, you change the beneficiary from your child
to your grandchild. The GST is designed to ensure that property
does not skip a generation without a transfer tax being imposed.
state plan may not meet your investment expectations.
You should choose from among the plans available one that meets
your risk tolerance and performance expectations. But what if
you are unhappy with a plan's investment performance? If
your plan allows rollovers, you can move the funds into another
qualified tuition plan. If you simply request a refund, you'll
have to pay income tax and penalties on the distribution.
federal income tax rules apply to all qualified tuition plans. However,
each plan has unique features. Nearly every state offers a 529 plan.
For details on each state's prepaid tuition program or college savings
plan, visit www.collegesavings.org.
Beginning in 2002, private institutions can also offer plans. Here are
some items you should compare when you evaluate different plans.
Flexibility in making contributions.
Withdrawal fees and penalties.
Transferability to another beneficiary or another qualified plan.
Choice of schools.
Beneficiary age restrictions.
Covered education expenses, including restrictions on room and
plans provide an attractive and tax-favored way to save for college.
However, they are not the right choice for everyone. Give us a call
to discuss all your education funding options. We can help you choose
a plan of action that is suitable in your situation.