College education costs are increasing at about twice the rate of inflation. This presents a real challenge to families saving for higher education expenses. They may have trouble finding risk-appropriate investments that earn enough to keep pace with rising education costs. They certainly do not need taxes on investment growth slowing them down. Fortunately, there are tax-advantaged ways to save for higher education, such as 529 Plans. Created by Section 529 of the IRS code, the state-operated 529 Plans are now offered by every state in the country and are becoming a very popular option for college education savings.
Two types of 529 Plans exist: Prepaid Plans and Savings Plans. Prepaid Plans allow the purchase of contracts or prepaid credits for college tuition at today's prices. The tuition credits will be redemed by the beneficiary at the time of college attendance. 529 Prepaid Plans allow families to lock-in today's college costs at in-state public colleges. If the student decides to attend a private or out-of-state college, their Prepaid Plans may not pay the full costs. Higher education institutions are allowed to offer their own Prepaid 529 Plans that are not affiliated with the state sponsored plans. One such example is the Independent 529 Plan for private institutions.
The 529 Savings Plans differ by allowing contributions to an account with tax-free growth and tax-free withdrawals when used for qualified higher education expenses. Contributions are non-deductible for federal income taxes but may be deductible for some state's income taxes. Qualified expenses include tuition, fees, books, supplies, reasonable costs of room and board, and other items required by the institution for enrollment or attendence. The Pension Protection Act of 2006 made permanent the federal income tax exclusion for qualified withdrawals. The account owner has some flexibility in choosing the investment strategy for the 529 Savings Plan, but the investment strategy may only be changed once per calendar year.
The IRS states that the 529 contributions "cannot be more than the amount necessary to provide for the qualified education expenses of the beneficiary." Each state sets the contribution limit for their 529 Plans somewhere around $300,000 per beneficiary. If a family wanted to contribute more than the total limit, they could open 529 Plans in multiple states. High-income taxpayers do not encounter any phase-out restrictions for 529 contributions, probably because contributions do not directly benefit the donors. Contributions only benefit the donors if they would otherwise be paying the beneficiary's education costs with after-tax dollars, or if they would otherwise have a large taxable estate that could be reduced with gifts.
Contributions to 529 Plans are considered completed gifts under federal gift tax regulations. For 2009, contributions in excess of $13,000 per donor, per recipient, per year count against the $1,000,000 lifetime gift tax exemption. For example, two parents who have three children could give $26,000 (2 x $13,000) to each child for a total of $78,000 (3 x $26,000) per year while remaining below the gift tax exclusion amount. The donor may contribute more in one year by making a special five calendar-year election and filing IRS Form 709. For 2009, the special five calendar-year election allows a donor to give up to $65,000 (5 x $13,000) to a beneficiary in one year if they do not give that beneficiary any additional amounts within a five year period.
All 529 Plans must have a designated beneficiary, the student for which the plan is established. 529 plans are established on a per beneficiary basis. For example, a family wanting to save for three children would need to establish three 529 Plans. The family has the option to rollover assets from one 529 Plan to another or change the plan beneficiary to another family member without tax consequences. See the "Rollovers" section of IRS Publication 970 Chapter 8 for the list of qualified family members. If the new beneficiary is not an IRS-defined family member, the change is treated as a non-qualified distribution and all earnings in the 529 Plan become taxable to the account owner. The investment strategy for the 529 Plan may be changed whenever a new beneficiary is assigned.
For distributions from 529 Plans that are not used for qualified higher education expenses, the portion representing the amount contributed is non-taxable and the portion representing the amount of earnings is taxable. The taxable portion of a distribution is calculated on a pro rata basis. For example, a family contributed $16,000 to a 529 Plan, and the balance grew to $20,000 (80% contributions; 20% earnings). If $5,000 was withdrawn and not used for qualified higher expenses, $1,000 of the distribution (20% attributed to earnings) would be taxable. The taxable portion of distributions will generally incur a 10% penalty tax as well. An exception to the 10% penalty tax may be allowed if the beneficiary has died, become disabled, or received a scholarship or educational assistance that is not a gift or inheritance.
Funding college education is one of the biggest expenses many families will ever incur. Considering the rapid rate at which education costs are rising, those families should begin saving as early as possible. Tax-free 529 Plans can help families achieve this important goal. Our government has provided tax advantages to those saving and paying for higer education because it sees education advancement as a social benefit to society. Make use of these tax benefits. When saving for higher education, consider investing with 529 Plans to combat the challenge of increasing education costs by saving taxes and keeping more of those dollars earned.
Sources: IRS Publication 970, FinAid.org, SavingForCollege.com
