Tuesday, December 27, 2005

529 Plans

Becoming a parent for the first time has caused me to give much consideration to paying for college. There are many programs that facilitate this process, but I believe the best college savings vehicle for most situations is the Section 529 plan, so named because the tax benefits that result from the plan are identified in Section 529 of the Internal Revenue Code. It is important to note that, although 529 plans were “created” by the federal government, they are run by all 50 of the individual states (at the time of this post, anyway…rumor has it that Wyoming is mulling the consolidation of its plan with Colorado). As such, the plans are not all created equal, and general statements about the plans may or may not apply universally.

Keeping in mind the above caveat, there are essentially two types of 529 options: prepaid tuition and a more general savings plan. Today I am going to focus on the general savings plan, and will address the prepaid approach in a future post.

The general savings approach within a 529 allows for substantial funds to be set aside to grow on a tax-free basis, as long as the funds are ultimately used toward educational purposes. I say “substantial” rather than a specific dollar limit because the maximum allowable contribution varies by state, as do many of the terms of these plans. If the money set aside in the funds is not used for education purposes, income tax will be assessed on the earnings when they are withdrawn, and a 10% penalty will be levied. Some notable aspects of the plans include:

  • Unlike prepaid programs, these general savings plans allow for the funds to be used at any legitimate educational institution. By way of example, Nevada allows for a maximum of $250,000 to be saved, and Arizona allows for $289,000.
  • The owner of the account, who is also typically the primary contributor, controls the account. This generally means that the beneficiary does not have much control. A key control feature is the ability for the owner to change beneficiaries on an account. For example, if a given beneficiary graduates high school and decides to pitch for the Cubs instead of going to college, the account owner can shift the funds to the budding Cy Young’s younger sibling without paying any penalties.
  • Residents of any state can typically invest in 529s from any other states, but some states provide a tax deduction to residents who use the state plans. For instance, Illinois offers a state tax deduction for contributions of up to $10,000 per year, or $20,000 for taxpayers who are married and filing jointly. For residents of states that offer the deduction, that is the first place to look, in my opinion. The deduction may not overcome a poorly managed plan, however.

The tax free withdrawal benefits conveyed by these plans are currently covered under the tax law through 2010. It is generally assumed that these benefits will be extended, but it’s definitely not guaranteed. Nonetheless, the average 18 year old beneficiary, who will be responsible for the taxes, will typically be in a lower tax bracket than the contributor. Thus, the benefit remain would remain, although it would be dramatically reduced.

What to look for in a 529 plan

In choosing a 529 plan for my children, I evaluated options based on several criteria. Some that I think are particularly important include:

  • Ability to take advantage of state tax deductions for residents. I live in Arizona, which does not offer this perk, but it would definitely be a key consideration if I lived in a state like New Mexico, which offers full deductibility.
    Investment performance.
  • Low fees and expenses. This is key, as these expenses reduce the investment return. I’m not a financial advisor and suffer from no conflicts of interest, so I can freely state that I like Vanguard mutual funds because they tend to have low expenses. Many 529s either use Vanguard to run the program, or leverage their funds within the plan.
  • Several investment options. Many plans offer age-based portfolios, which simply provide asset allocation that is appropriate given the number of years remaining before a beneficiary hits 18 years old. Basically, the longer away 18 is, the higher the allocation to risky financial assets, i.e. stocks. As college approaches, the fund shifts to less risky assets. This is a nice feature for people who are not particularly inclined toward asset allocation theory.
  • Minimum contribution levels that are appropriate to a given situation. If a new parent wants to start saving for college with $100, and a plan requires $3,000 to open an account, the plan is obviously not a good fit.
    Maximum contribution. The higher the maximum contribution limit, the better.

Research is required to decide which plan to adopt for a given situation, but a few caught my eye. The College Savings Plan of Nebraska is considered by some to be the best in the country. For the most part, its expenses are very low, and the breadth of investment options is impressive. It offers a stingy tax deduction for residents, but something is better than nothing. The Utah Educational Savings Plan (UESP) Trust has low expenses and a contribution limit of $315,000. Nevada offers several well regarded 529 options, including The Upromise College Fund, which is managed by Upromise Investments, and leverages Vanguard funds. This is the plan that I selected, because it works seamlessly with the Upromise program, which I also recommend. For those who have not consumed the Upromise Kool-Aid, as I have, Nevada also offers The Vanguard 529 Savings Plan, which is also managed by Upromise and has similarly low expenses, with an even wider choice of investment options. I also think Illinois’ Bright Start College Savings Program, which is managed by Citigroup Asset Management, is solid, particularly for Illinois residents.


13 Comments:

At 10:13 AM, Anonymous Todd said...

So - I was also under the impression that grandparents or others can contribute to a 529 without gift tax implications - is that true?

Like Matt's grandparents can put $20K into his 529 without tax implications for either side.

Can you clarify?

 
At 10:13 AM, Anonymous Todd said...

So - I was also under the impression that grandparents or others can contribute to a 529 without gift tax implications - is that true?

Like Matt's grandparents can put $20K into his 529 without tax implications for either side.

Can you clarify?

 
At 10:14 AM, Anonymous Todd said...

Did I hit publish twice?

 
At 8:45 AM, Anonymous Todd said...

Lemme aks you this then

Wouldn't a students eligibility for financial aid be affected by a large balance in a 529 plan?

Wouldn't it then be better if the parents just invested the same amount as they would in a 529 but in a diferent account which would not appear as a 529 in the childs name?

Or is it that student financial aid is based on the wealth of the parents more so than the 529 balance of the child.

Also would the tax benefits outweigh this anyway?

enquiring minds want to know

 
At 10:39 AM, Blogger Kevin O'Reilly said...

Todd -

Good question about the 529 impact to financial aid eligibility. A new law helps clarify the issues, but the bottom line is that no 529 plans count as student assets in the financial aid calculation, even if the student is the holder of the 529 plan. In the latter case, it is not clear whether or not a student-"owned" 529 will be treated as a parental asset. Regardless, if it is treated as such, only a maxiumum of 5.6% of the 529 plan account will be considered an expected contribution to school costs. The big caveat here is that the 529 tax exclusion is set to expire in 2010. If it is not renewed, all bets are off.

 
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