Section 529 Plans: Saving for Education
Section 529 Plans: Saving for Education
An education is one of the best investments you can make for your child’s future. But the high cost of education may alarm you — especially if you’ve waited too long to begin saving. For example, a Coverdell Education Savings Account (formerly referred to as the Education IRA), with its annual contribution limit of $2,000, won’t offer much help if your child is already in high school. And prepaid tuition plans are attractive, but only if your child is willing to attend a school that participates in the plan.
Fortunately, there’s another option. Created in 1996, state-sponsored savings plans (or Section 529 plans, named after the IRS code that created them) allow flexibility in choosing a school and the opportunity for late starters to make sizable investments while reaping tax breaks.
How the Plans Work
Section 529 plans allow individuals to invest in a predetermined pool of stock and bond investments. Most plans will require you to divide your investment according to a given asset allocation determined by your child’s age. In general, the asset allocation will be more aggressive for younger children and less aggressive for children nearing college age.
Lifetime contribution limits to Section 529 plans vary from state to state, but they typically exceed $200,000 and offer some flexibility on when you can contribute. In addition, there are no income thresholds and typically no annual contribution limits, although annual contributions of more than $15,000 ($30,000 when made jointly with a spouse) may require filing a federal gift tax form. You may contribute five years’ worth of gifts all at once, or $75,000 per beneficiary, without potentially triggering the federal gift tax. All earnings in the account grow tax deferred. If you live in the state where the plan is administered, you also may be eligible for state tax deductions. Please consult with your tax professional concerning your situation.
Section 529 plans may be used to fund qualified expenses at post-secondary educational institutions, and starting in 2018, up to $10,000 per year may be used to fund expenses for K-12 educational expenses as well. Assuming that you have followed the plan’s rules, there will be no penalties (nonqualified withdrawals will be subject to a 10% additional federal tax in addition to ordinary income taxes). And qualified withdrawals are tax free. If there is money left over in the account, the beneficiary designation can be changed to a sibling, first cousin, or other family member (as defined by the Internal Revenue Code) of the original beneficiary without triggering gift taxes.
Pros and Cons
Flexibility in contributions and choice are the biggest advantages of Section 529 plans over other tax-deferred education savings vehicles. Even though these plans are state-sponsored, you do not need to be a resident of the state to participate, although you may lose out on state tax benefits by participating in an out-of-state plan.
Apart from tax savings, these plans offer the advantage of professional asset management. Each state contracts with a single asset management firm to oversee the plan, so by comparing various state plans, you’ll be able to choose from several professional management companies. For more information on each state’s plan, visit www.savingforcollege.com. This website includes graphical ratings that compare the plans and links to plans that have websites.
The primary drawback to Section 529 plans is investment risk. Unlike state-sponsored prepaid tuition plans, returns from Section 529 plans are not guaranteed. This means that your investment could lose value, perhaps just as your child is ready to use the funds. Although the firms that manage Section 529 plans use less-risky asset allocations to reduce risk as your child grows older, risk cannot be eliminated altogether.
You’ll also want to have a thorough understanding of contribution and withdrawal rules before investing in a plan, since rules vary depending on the state. Pay particular attention to rules regarding transfers, early withdrawals, or withdrawals for things other than education expenses. Additional federal taxes are imposed if withdrawals are not used for qualified education expenses (generally 10% on earnings only).
Choosing the Plan That’s Best for Your Family
Section 529 plans are just one of the options you have for education savings. They offer a great deal of flexibility in exchange for a higher level of investment risk. If you’re getting a late start or if your child is unsure of which school he or she wishes to attend, a Section 529 plan may be your best choice.
But if you’re starting early on saving for college, you might consider a prepaid tuition plan. This plan allows you to lock in today’s tuition rate, which can mean a savings of thousands of dollars in college costs. Prepaid tuition plans guarantee payment of a semester’s tuition for each unit that you buy, and payments may be spread out over several years. Almost all prepaid tuition plans are more restrictive when it comes to choosing a college, and they may also be more restrictive in terms of withdrawals. Applicants will typically receive a list of participating colleges that a child can attend. If the child wishes to go to a school outside the plan, the value of the investment may be reduced.
As with any financial planning decision, the choice that’s best for you will depend on your unique situation, including your risk tolerance and the number of years until your child begins using the funds. Another consideration is your child’s plans. Does he or she even plan on attending college? If so, has he or she chosen a school? Talk with your child about college, then make an appointment with your financial advisor to find the plan that best suits your needs.
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