529 plans
A college savings strategy that makes the grade

As the cost of a college education continues to soar, it’s more important than ever to design an investment strategy that prepares your family for this major expense. Over the last several years, the 529 plan has emerged as perhaps the most powerful tool for financing higher education costs. And the recent expansion of the “kiddie tax” has further enhanced the 529 plan’s advantages over other options.

Why do 529 plans score so high?

529 plans are education investment accounts operated by states and certain educational institutions. Contributions to a 529 plan aren’t federal-tax deductible, but some states allow a deduction. Earnings can be withdrawn tax free so long as they’re used to pay qualified higher education expenses, including:

• Tuition and fees,
• Books, supplies and equipment, and
• Certain room and board costs.

There are other benefits to 529 plans, such as:

Generous contribution limits. Most states allow you to contribute between $200,000 and $300,000 on behalf of a single beneficiary.

Control. 529 plans allow you to enjoy significant tax advantages while retaining a great deal of control over the funds, including the power to change beneficiaries, transfer the funds to another 529 plan or even revoke the account (subject to penalties). Typically, you have less control with other savings tools.

Minimal impact on financial aid. 529 plan assets are generally considered to be the property of the parent or grandparent — rather than of the student — so the impact on financial aid eligibility is minimized.

Gift tax relief. Contributions to a 529 plan, like other college savings accounts, are taxable gifts to the beneficiary. You can minimize gift taxes, however, by taking advantage of the annual gift tax exclusion, which allows you to give up to $12,000 ($24,000 for married couples) to each recipient gift-tax free.

Unlike other college savings accounts, a 529 plan allows you to accelerate up to five years’ worth of annual exclusions. That means you can make a contribution in the first year of up to $60,000 ($120,000 for a married couple) free of gift taxes — and the assets are removed from your taxable estate. But if you die before the five-year period ends, a portion of the gift may be included back in your estate.

No kiddie tax issues. A child subject to the kiddie tax must pay tax on unearned income at his or her parent’s marginal tax rate. Until recently, the kiddie tax applied to children under age 14. So an effective college savings strategy was to transfer appreciated securities or other assets to a child, who could liquidate the assets after age 14 and pay tax at his or her own lower rate, reaping overall tax savings for the family. But effective in 2008 for most taxpayers, the age threshold has been raised to age 19 — and to 24 for full-time students — eliminating the advantages of this strategy. Shifting assets into a tax-free 529 plan avoids any kiddie tax issues.

Are you doing your homework?

If you have college-bound kids or grandkids, there’s no doubt that you should consider a 529 plan. Keep in mind that contribution limits, investment approaches and tax advantages vary from state to state, so be sure to shop around for a plan that best meets your needs. •