February 4, 2005 -- The introduction of Section 529 plans in 1996 provided families with a new way to save for college.  Since education costs have been increasing at rates significantly higher than inflation, the need to prepare for this major expense has become more pressing for families at all income levels.  Initially, the tax provision allowed income in a 529 plan to grow tax deferred and to be taxed when withdrawn and used for college education costs at the presumably low marginal rate of the student.  The Economic Growth and Tax Recovery Act of 2001 made qualifying Section 529 distributions exempt from federal income tax.   (This tax exemption, however, is scheduled to expire on December 31, 2010 and Congress may or may not extend the exemption.  Proposals to make this benefit permanent have been proposed.)  

Instead of focusing on the basics of 529 plans, since much has been written on these arrangements, our focus will be on a few specific areas that may be of interest. We will examine when other savings programs may be a suitable alternative to the 529 plan.  Also, where 529 is determined to be the best savings vehicle, we will compare some of the different tax and program attributes of the plans sponsored by Pennsylvania, New Jersey and Delaware.

Alternatives to Section 529

For many years, parents have utilized UGMA/UTMA accounts to accumulate funds for their children’s college expenses.  Income earned in a UGMA/UTMA account is reportable on the child’s tax return.  For children up to age 14, however, investment income over $1,500 will be taxed at the parent’s rate.  By investing in vehicles that generate little or no current income (Savings bonds or index funds for example), the tax burden can usually be managed during the accumulation years.  When funds are withdrawn to pay for college costs, the income tax incurred may be offset by the Hope Credit, the Lifetime Learning Credit or the Tuition and Fees deduction available for students who are not claimed as dependents on their parents’ returns.  Therefore, for families whose income levels significantly reduce or eliminate the benefit of the dependency deduction, the use of a UGMA/UTMA account may be the simplest and most cost effective arrangement.  These accounts provide investment flexibility and there are no fees associated with the maintenance of such an account.  Annual exclusion gifts from the parents reduce the parents’ estates.  On the negative side, the funds in a UGMA/UTMA account will become available to the child at majority (usually age 21).  Many parents do not consider this a significant concern, as they anticipate the funds will have been expended for college prior to this time, or that they will have sufficient influence on their child to help direct the use of the money remaining when the child reaches 21.    Assets in a UGMA/UTMA account are considered part of the child’s assets, so they will reduce the amount of financial aid otherwise available.  Parents who expect to qualify for financial aid should therefore not use UGMA/UTMA accounts.

Coverdell Education Savings Accounts allow annual contributions of up to $2,000 per beneficiary who has not yet reached age 18.   Individuals with Adjusted Gross Income over specified limits may not contribute to a Coverdell Account.  However, the limits are fairly high ($190,000 to $220,000 for joint filers and $95,000 to $110,000 for all others).  Earnings are tax deferred and on distribution are not taxable if used to pay qualified education expenses.  Earnings not used for education are subject to income tax and to a 10% penalty tax.  Amounts not used for education must be distributed to the beneficiary when they reach age 30.  Because of the simplicity of the Coverdell arrangement, these vehicles may make the most sense for families with limited funds to direct to a college savings program.  Or, if parents fully utilize their annual exclusions contributing to 529 plans, the child could establish a Coverdell account with earnings from part time jobs or previously accumulated savings.  

Series EE or I Savings Bonds can also be used, and the income will be tax free if used for qualifying expenses.  However, the bonds must be issued after 1989 to a person at least age 24 at the time of issue (so they cannot be bought in the child’s name) and the exclusion of income phases out when the owner’s adjusted gross income in the year when the bonds are cashed in  exceeds $87,750 on a joint return, $0 on a married filing separate return and $58,500 for all others. 

529 Plans

Unlike many other tax-advantaged arrangements, there are no income limits imposed on the owner or beneficiary of a 529 plan account.  Taxpayers who are phased out of other possibilities will often turn to the 529 plan for college savings.

One of the benefits of using a Section 529 plan are the owner’s ability to “front load” the account, by contributing up to $55,000 ($110,000 where gift splitting is used), and electing to treat the contribution on their gift tax return as a 5 year gift, taking advantage of the annual exclusions from future years to offset the current gift.  If the owner of the account dies prior to the fifth year, a portion of the gift would be includible in the owner’s estate.  (For example, if death occurred in the fourth year of the five year period, 20% of the original gift would be included in the owner’s estate.)   This front loading allows the account to accumulate more quickly and is often an attractive feature for grandparents wishing to endow their grandchildren’s education.  Since direct payment of tuition does not use any annual gift exclusion, some wealthy individuals may benefit by funding a 529 plan enough to cover room and board, books and equipment costs and directly pay the cost of tuition as it becomes due.  This would free up a portion of the annual exclusion for other gifting purposes.

529 plans allow the owner to control the account and to redirect the account to another beneficiary.  Although often referred to as a “bad boy” clause, this feature can be helpful if there are excess funds or the original beneficiary does not need the funds for college because of scholarships.  No income tax would result in the change of beneficiary so long as the new beneficiary was a member of the family of the original beneficiary.  No gift occurs on the transfer of the account unless the new beneficiary is a generation below the original beneficiary.  (If the beneficiary were in a generation below, the original beneficiary would be deemed to have made a gift to the new beneficiary.)

Although not a provision expected to be used in most cases, 529 plan owners may take distributions from the plan, effectively “ungifting” the account.   Like the Coverdell account, earnings not used for education for the designated beneficiary will be subject to income tax and to a 10% penalty tax.  The distribution provision provides some comfort to those who wish to set up a 529 plan, but fear that unforeseen future expenses may arise that they would otherwise be unable to meet.

For financial aid purposes, 529 accounts are considered an asset of the account owner rather than the beneficiary, so they have less of an impact on eligibility than assets held by the student.  If the account owner is other than the parent or the child (a grandparent, for example), they would have no impact on the availability of financial aid.

Evaluating Different Programs

529 plans are offered by most states and some educational institutions.  Owners may choose among several investment options which accommodate different risk tolerance levels and the age of the beneficiary for whom the account has been established.  Individual investment selection is prohibited, although limited transfers among the sponsor’s options are allowed each year.  Amounts can be transferred to a 529 plan offered by a different sponsor as well if the performance or features of the original account are not satisfactory.

While most plans are set up as savings arrangements, some programs provide for the purchase of  tuition credits at, and sometimes a little below, current rates.  Rather than hope for a positive investment result from your mutual fund choices, if the credits are used to pay for tuition in the future, you will have “earned” the increase in the cost of tuition from purchase to the date needed to pay for college.  If the credits cannot be used (because the student wishes to attend a school that does not accept the credits, for example) a distribution based on the underlying asset performance can be received.  However, the annual return amount will frequently be capped at a modest level.  (For example, the Independent 529 plan, which represents a consortium of over 200 colleges nationwide, provides for a refund based on actual performance of the underlying investments with a maximum gain of 2% per annum and a maximum loss of 2% per annum.)

Locally, Pennsylvania offers a tuition credit plan available to residents only.  PA also sponsors a savings plan, available to both residents and non-residents.  PA does tax the excess of distributions received over original investment from an out-of-state 529 plan.  However, distributions from a PA plan are not subject to PA income tax.  Similarly, for PA inheritance tax purposes, PA exempts the assets of the PA account, but includes in the owner’s estate the value of an out-of-state program account.  Regardless of whether an in-state or out-of-state program is used, both New Jersey and Delaware follow Federal rules on the taxability of distributions and the estate tax treatment of 529 plans.  Investors from other states should first investigate their own state programs, as some states provide enhanced benefits for the use of their own program.

There are several mutual fund companies represented among the available 529 plans.  (Pennsylvania’s program is managed by Delaware Investments, New Jersey’s program is managed by Franklin Templeton and Delaware’s program is managed by Fidelity Investments.)  Most programs include an asset based management fee as well as small account maintenance fees each year.  The choice of the best program will require some homework on the prospective investor’s part.  One excellent source to review the available programs, their features and past investment results is www.savingforcollege.com. 

So which option is best? Like everything else in life, it depends.  The alternatives described above should be examined in light of each investor’s financial and tax situation, risk tolerance, time horizon and sensitivity to fees and paperwork.  With college costs on the rise at such a rapid pace, anything else could prove costly….literally.

For more information, contact Madeline Janowski at 215-564-1900 .

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