College Saving Simplified

While the tax law of 2001 brought good news to investors for many different reasons, it’s likely that parents and grandparents are among the most pleased. Offering valuable tax-saving incentives in education-funding alternatives, the tax law greatly enhanced state-sponsored 529 plans to assist in saving for college. They are now available in most states.
While details of each plan differ slightly from state to state, there are two major categories. The first is the 529 prepaid tuition plan. With this program, you lock in the future tuition of certain state colleges at the current rates. There are some downsides to these programs. One is that although you are guaranteed the amount of money needed to pay for tuition, you will not receive a return any higher than the increase in tuition. Secondly, most of these programs are restricted to residents within the state sponsoring the program.
The newer version—the 529 savings plan—gives you more options. You are permitted to make regular contributions to the account, subject to state annual and total contribution limits. From there, either a state agency or private company working for the state invests the contributed amounts for you. Many of the states allow non-residents to participate in their programs. This way if you aren’t happy with your own state’s plan, you may have other choices. Bear in mind, however, that tax benefits may be limited to in-state participants. Although there is no federal deduction of contributions, state deduction varies by state.
The investment earnings in the plan grow federally tax-deferred. When the time comes, you can withdraw from it as needed to pay for higher education expenses. Right now, you’re thinking what a help this is to pay for tuition, but what about the rest of the experience. More good news! The funds in the plan can be used for fees, books, equipment and supplies as well. The earnings portion of the distribution is exempt from federal taxation as long as the distribution is used for qualified education expenses. Students are limited to accredited schools, which may include trade programs offered at culinary and vocational institutes.
Should you be the proud parents of a child who is granted a scholarship, the funds can be withdrawn without penalty up to the amount of the scholarship. Another option is transferring the funds to another family member who is headed for college, with no penalty to you. If the investment is not used at all, you can withdraw the funds. However, the earnings portion of any distribution not used for qualified higher education expenses will be included as ordinary income to the person receiving the distribution and subject to a 10-percent penalty on the federal level. There may also be a penalty assessed on the state level and may actually differ from not only the federal penalty, but also from state to state.
There are even more advantages to these programs as contributions are considered completed gifts for gift tax purposes. This means your contributions could qualify for the $11,000 annual gift exclusion. A special exception to the $11,000 annual exclusion allows you to give larger gifts free of federal gift tax. An individual can choose to make as much as a $55,000 contribution in one year ($110,000 for married couples filing jointly) on behalf of a beneficiary. The $55,000/$110,000 contribution is, in effect, treated as five separate $11,000/$22,000 annual exclusion gifts (one for the current year, then one in each of the next four years). No federal gift tax will result as long as no other gifts are made to this beneficiary within the same five-year period. If you were to die during this five-year period, however, a portion of this gift would be included in your estate.
Talk to your financial adviser about the potential benefits that both types of 529 programs offer. Consult your legal or tax adviser to understand the particular tax consequences associated with your opening a 529 plan account. Your financial adviser can then assist you in conducting the necessary analysis to determine which education-funding strategies would benefit your unique situation.

Thomas Miller is an assistant vice president with UBS PaineWebber. He can be reached by phone at 816.360.2247 or by e-mail at thomas.miller@ubspw.com.