529 College Savings Plans
Ten common misconceptions revealed for taxpayers and investors.
September 13, 2007
by LeAnn Luna
Taxpayers have invested more than $100 billion in Section 529 college savings plans (“529-plans”). Section 529-plans offer significant federal tax savings, including tax exempt earnings and tax exempt distributions for qualified educational expenses. Furthermore, unlike other tax-favored investments, 529-plans are not subject to income phase-outs, and contributions are essentially unlimited. Also, 529-plans have estate and gift tax advantages. Investors may contribute up to $12,000 annually per beneficiary ($24,000 for joint spousal gifts) gift-tax free. In addition, the contributor may elect five-year averaging, thereby enabling a $60,000 contribution ($120,000 for joint spousal gifts) to each beneficiary in a single year without gift-tax consequences.
However, there are still many aspects of 529-plans that confuse potential investors. Here are the 10 most common misperceptions.
- The 529-plan I chose years ago is still the best plan for me.
Just as investors should not assume that the mutual fund they selected years ago is still the best investment going forward, 529-plan investors should remain on the lookout for better options. Section 529-plans are still in their infancy and competition among the states for investors has led to dramatic changes in the 529-plan landscape over their brief history. There are now more than 80 savings plans to choose from, with many opening in the last few years, and many existing plans have changed investment managers, expanded investment options, and changed the fee structure. Tax-free rollovers between 529-plans are generally available once per year.
- 529-plans are a new twist on prepaid tuition plans.
States currently sponsor two types of plans for college. Prepaid tuition plans allow contributors to purchase tuition units redeemable in the future at many U.S. colleges and universities, thereby locking in future tuition costs at today’s tuition rates. However, these plans generally limit college choices to those who participate in the particular prepaid tuition plan. While prepaid plans were introduced prior to savings plans, only 16 plans are in existence today. Funds withdrawn from a 529 college savings plan can be used at any accredited college in any state.
- The 2010 sunset will eliminate the most favorable tax benefits.
Congress made permanent most existing tax benefits, including tax free withdrawals of qualified education expenses with the Pension Protection Act, which was signed by the President on August 17, 2006.
- I can only get a tax deduction for contributions to my in-state plan.
The tax treatment varies considerably from state to state, therefore investors are advised to check their own state’s rules carefully. Most states (and Washington D.C.) that impose state income tax on their residents currently offer a tax deduction for residents’ contributions to the in-state plan, but eight states offer no deduction to any plan (Alabama, California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota and New Jersey). Furthermore, four states offer their residents a deduction to any 529-plan (Arizona in 2008), Kansas, Maine and Pennsylvania). Several plans offer residents incentives in addition to state tax deductions, such as contribution matching, credits, reduced fees, and in-state tuition if the family were to relocate out-of-state. However, these rules change often, so check only up to date information outlets.
- If my state offers a tax deduction, I should choose that plan.
The tax deduction is valuable, but investors are advised not to be held hostage to the in-state plan’s tax benefits. Since most investors will hold their 529-plans for many years, a plan’s ongoing fees, expenses and investment options can easily outweigh one-time tax benefits. Investors should weigh the tax deduction, especially if they will invest a relatively small amount each year, but only as a single factor in the overall investment decision.
- 529-plan proceeds can only be used for tuition.
Distributions from a 529-plan are not taxable when used for qualified education expenses. This definition includes tuition at most accredited post-secondary educational institutions, including many vocational schools. Qualified expenses also include fees, books, supplies and equipment required for attendance, and most room and board costs if the student is at least half-time.
- 529-plans will jeopardize financial aid.
In most cases, the owner of the 529-plan is the beneficiary’s parent or the grandparent, not the actual beneficiary. Because parents’ assets are taxed for financial aid purposes less heavily than students’ assets, this is a significant benefit. Further, a student’s financial aid status will not be affected at all when a grandparent establishes a Section 529-plan for his or her grandchild, as these assets are not currently included in the financial aid calculation.
- Section 529-plans hold baskets of mutual funds.
Although many of the nation’s best known fund companies also manage the investments for these plans, 529-plans are in fact municipal securities and therefore, are not subject to the same regulations as some other investments, such as mutual funds. Fees, returns and other standard disclosures are not required and Section 529 brokers are not treated as “securities dealers” subject to SEC oversight. Disclosures, in particular, have improved recently, but the investments are less regulated than their mutual fund cousins.
- Donors lose control of their investment.
Because the contributor is deemed to be the plan owner, the owner retains the right to control distributions and to change plans, beneficiaries, and investment choices. These advantages make the 529-plan far superior to other options such as Uniform Gifts to Minors Act (UGMAs), where the donor must give up control to get favorable gift and estate tax treatment.
- I’ll be penalized if my child gets a scholarship.
In general, funds earnings withdrawn from a 529-plan and not used for qualified education expenses are taxed at ordinary tax rates and subject to a 10 percent penalty. However the 10 percent penalty on 529-plan earnings withdrawn does not apply in cases of death or disability of the beneficiary, and the amount subject to penalty is reduced by the value of any scholarships received. Furthermore, account owners can use the plan assets to further their own education, or change beneficiaries to other family members, including nieces, nephews and first cousins of the original beneficiary, without tax or penalty.
I’ll cover several other misconceptions about 529 plans in an upcoming issue of AICPA Tax Insider.
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LeAnn Luna is an assistant professor and holds a dual appointment with the Department of Accounting and Information Management and the Center for Business and Economic Research, both at The University of Tennessee.