There
are many ways to save for college, but one thing is certain: it is never
too early to start. One relatively new way to save for college is a qualified
tuition program (QTP), or "Section 529" plan. These plans offer a way to
pay for college expenses with some nice tax advantages. The 2001 Tax
Act expanded the benefits of these plans.
What
are they?
Qualified
tuition plans allow you to set up a tax-advantaged account for your child's
college education. There are two types of Section 529 plans: prepaid tuition
programs and college savings plans.
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Prepaid
tuition programs let you lock in today's tuition costs by purchasing
tuition credits or certificates that a student redeems when he starts college.
Prior law limited these plans to state-run plans. However, The 2001
Tax Relief Act permits education institutions to establish and maintain
prepaid tuition plans beginning in 2002.
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College
savings plans let you make contributions to a state-sponsored savings
account to build a fund for your child's college expenses. These accounts
are generally managed by a private mutual fund company. |
How
do they work?
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Make
a gift to set up an account. You start by setting up a qualified
tuition plan account and naming your child (or anyone else) as the beneficiary.
Your contribution is considered a gift. Your contributions qualify for
the $11,000 annual tax-free gift exclusion ($22,000 for married couples
making a joint gift).
Special
rules for 529 plans let you average your gift over five years. This means
married couples can make a $110,000 joint gift and individuals can make
a $55,000 gift in a single year, without incurring gift tax. However, you
cannot make additional gifts to your child for five years, or you may owe
gift tax.
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Your
contribution is limited. You aren't permitted to make contributions
to a 529 plan beyond what is necessary to pay for your child's college
expenses. Each plan sets its own limit. Generally, your contributions to
a prepaid tuition program will be limited to the number of credit hours
that it takes to obtain a degree. Savings plans usually limit your contributions
to the estimated cost to attend the colleges eligible under that state's
plan.
Most
plans allow you to make either a lump sum contribution or a series of monthly
contributions. All contributions must be made in cash; you can't contribute
shares of stock or other property to these plans.
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You
remain in control. You cannot choose the investments in the fund
— a fund manager does this. However, you do remain in charge of
all withdrawal decisions. You can allow your child to make withdrawals
to pay for college expenses. If your plan permits it, you can change the
beneficiary to another family member without losing the tax benefits. If
you change your mind about maintaining the account, you can even request
a refund (tax and penalties will apply).
Other
types of accounts, such as education savings accounts (previously called
education IRAs) and custodial accounts, don't offer this control. Once
you set up these accounts, your child is the legal owner. As long as your
child is a minor, you may control the investment and withdrawal decisions.
However, in most cases your child can withdraw funds, for any purpose,
when he or she reaches legal age (18 or 21 in most states).
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Your
child can withdraw money to pay for college expenses. Section 529
funds must be used for qualified higher education expenses, such as tuition,
fees, books, and supplies. They can also be used to cover certain room
and board expenses, as long as your child attends school at least half-time.
If your child receives a scholarship, you can request a penalty-free refund
up to the amount of the scholarship. In addition, you can withdraw the
funds if your child becomes disabled or dies.
If
the funds are withdrawn for any other purpose, you (not your child) pay
tax on the earnings that have accumulated in the fund. The new law repealed
the required plan-imposed penalty and replaced it with a 10% excise tax.
However, your plan may still charge withdrawal fees.
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You
can change plans. Prior law allowed a tax-free and penalty-free
rollover from a QTP for your child to a QTP for another family member.
Now you can make a tax-free rollover to another plan with the same beneficiary.
That allows you to move your child's plan to another state's plan or to
change your child's state-run plan to one run by a private institution
without losing the tax benefits. This tax-free rollover treatment only
applies to one transfer within any 12-month period.
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What
are the benefits?
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Section
529 plans offer tax benefits. Your contribution is not tax-deductible,
but your investment grows tax-deferred. That allows your money to grow
faster than a similar investment in a taxable account. Qualified distributions
from state-run plans are tax-free. After 2003, this tax-free status applies
to qualified distributions from nonstate plans as well.
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Compare
Section 529 plans to other education saving options. Qualified
tuition programs have some advantages over other tax-favored ways to save
for college.
Education
savings accounts permit you to set aside up to $2,000 per year in a child's
name, much less than what you're able to put into 529 plans. You can't
contribute to an education savings account once your adjusted gross income
reaches certain levels. Anyone can contribute to a 529 plan — it
doesn't matter how much you earn.
Education
savings bond interest (Series EE and Series I bonds issued after 1989)
is tax-free if you meet certain requirements and use the funds to pay for
college tuition and fees. The tax status of 529 plans depends only on how
the funds are used.
Custodial
accounts usually produce taxable income for your child. That generally
means preparing tax returns and paying taxes each year. The money inside
a Section 529 plan grows tax-deferred, and after 2001, the earnings are
tax-free if the funds are used to pay for qualified college expenses.
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Section
529 plans offer an estate planning opportunity. The 2001 Tax
Relief Act gradually reduces estate taxes over the coming years and
repeals them entirely in 2010. In the meantime, Section 529 plans let wealthy
parents or grandparents transfer wealth out of an estate and into an account
a child can use to pay for college expenses.
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What
are the disadvantages?
While
these plans offer an attractive alternative to other college funding plans,
they are not without drawbacks. There are a number of factors you should
consider before you invest in a qualified tuition plan.
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Substantial
penalties apply to nonqualified withdrawals. What if there are
funds left in the account after your child completes his college education?
What if you change your mind about sending your child to college? What
if an emergency arises, and you need the funds for yourself? You may request
a refund, and the account will be refunded according to your plan's policy.
However, any nonqualified distributions will be subject to withdrawal fees
and penalties. You'll also owe income tax on the distribution.
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Watch
out for the GST trap. Generally, changing beneficiaries to another
member of the family doesn't trigger tax. However, when you change a beneficiary
to a family member that is a generation below that beneficiary, the generation-skipping
tax (GST) will apply. For example, you change the beneficiary from your
child to your grandchild. The GST is designed to ensure that property does
not skip a generation without a transfer tax being imposed.
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Your
state plan may not meet your investment expectations. You should
choose from among the plans available one that meets your risk tolerance
and performance expectations. But what if you are unhappy with a plan's
investment performance? If your plan allows rollovers, you can move the
funds into another qualified tuition plan. If you simply request a refund,
you'll have to pay income tax and penalties on the distribution.
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Do
your homework.
The
same federal income tax rules apply to all qualified tuition plans. However,
each plan has unique features. Nearly every state offers a 529 plan. For
details on each state's prepaid tuition program or college savings plan,
visit www.collegesavings.org.
Beginning in 2002, private institutions can also offer plans. Here are
some items you should compare when you evaluate different plans.
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State
income taxes. |
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Investment
return. |
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Enrollment
fees. |
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Maximum
contributions. |
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Flexibility
in making contributions. |
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Withdrawal
fees and penalties. |
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Transferability
to another beneficiary or another qualified plan. |
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Choice
of schools. |
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Participation
by nonresidents. |
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Beneficiary
age restrictions. |
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Covered
education expenses, including restrictions on room and board. |
State
tuition plans provide an attractive and tax-favored way to save for college.
However, they are not the right choice for everyone. Give us a call to
discuss all your education funding options. We can help you choose a plan
of action that is suitable in your situation.
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