SECTION 529 COLLEGE SAVINGS PLANS

Some Questions and Answers

How do they Work?
An "account owner" puts away money in the plan for a "beneficiary" whom they expect will attend post secondary schooling in the future. The account owner can be any age and there are no income requirements or restrictions. The account owner does not have to be related to the beneficiary, although most are, with grandparents being a very popular choice. The account owner controls the account and holds most of the power to make decisions regarding beneficiaries and disbursements. They can even take the money back, although penalties would probably apply. The account owner can also be a beneficiary. This might be attractive to an adult contemplating graduate school. Most documents also allow for the selection of a successor owner if the original owner dies. This person should be carefully chosen in view of the broad power they hold.

Who can be a beneficiary?
Anybody. Once again, there are no age, income limitations, or relationship requirements. The account owner has the right to change the beneficiary to other members of the beneficiary's family (spouse, child, parent, sibling, niece/nephew, aunt/uncle, first cousins, or in-laws). This gives the owner a great deal of flexibility and comfort knowing that funds can be reallocated to other beneficiaries if situations change. However, changing a beneficiary could have gift tax implications that are discussed under estate planning issues.

How much can be contributed?
Although the federal law does not specify an amount, each state determines a ceiling based on their interpretation of the most expensive school for an under-graduate degree. Many states have ceilings in the $250,000 range and all allow at least $110,000. The maximum can work in a couple of ways: a limit may be set on total contributions; they may allow contributions until the plan balance reaches the ceiling; or both. Also considered as contributions are amounts transferred to a beneficiary under the change of beneficiary rules. If a plan uses the contribution approach, it would probably be advantageous to "front load" the plan as much as possible so that account appreciation does not limit your contributions.

Contributions may only be made in "cash" (which actually means by check), therefore not offering the opportunity to use appreciated securities. Contributions are recorded on a calendar year basis and some states refer to the date a check is cashed rather than when it was issued or sent. Technically, you can fund more than one state's plan, up to each state's maximum under current law, but we would caution investors not to get "carried away" because the loophole may be closed or at least set aside if the amount saved is deemed unreasonable.

Is there a minimum contribution?
Plan Administrator requirements may vary. It is necessary to review the specific terms of each plan to determine what, if any, minimum contribution limits may exist.

What are the income tax benefits?
There are significant tax benefits that apply to "qualifying" distributions. Contributions grow within the plan on a tax-deferred basis for both federal and state purposes. Anybody familiar with retirement plans such as IRAs can appreciate the wealth-building feature of tax-deferred growth. Amounts that are withdrawn for the beneficiary's qualified expenses will be received federally tax-free (state taxes may apply). Needless to say, this is a tremendous advantage for college savers.


Qualifying expenses include: tuition, books, supplies, fees, and room & board (if at least half-time) paid to an accredited institution of higher education. Any school that the US Department of Education determines to be student-aid eligible qualifies, which includes any reputable US school and even some foreign schools. To ensure that funds are used for the intended purpose, the plan sponsor typically will only issue checks payable to the institution with the beneficiary as an additional signatory.

What if the money is withdrawn for other purposes?
These "non-qualified" withdrawals, to the extent they represent earnings, are taxed to the account owner, not the beneficiary. Plan sponsors levy a penalty typically amounting to 10% of the taxable portion received. The penalty is applied before the distribution is made and is not a tax but, rather, an amount withheld and paid to the plan sponsor. Also, the taxable portion of amounts withdrawn may be subject to a federal 10% tax penalty, similar to the rules for IRAs. This replaces the requirement that plan sponsors must impose a penalty of their own - however, they may continue to do so. You still get your contributions back (assuming positive returns) and 80-90% of the earnings. The penalty is waived in the case of death or disability of the beneficiary.

Can money from other education accounts be transferred into a 529 plan?
Yes, but it is important to realize that the investments in any of these accounts must be liquidated to cash prior to transfer. Transfers from UGMA/UTMAs are allowed, as long as the right to change beneficiaries in the future is waived since UGMA/UTMA funds are irrevocable gifts. Distributions from an Education IRA (now known as Coverdell Savings Plans) "rolled over" to a 529 would be considered a "Qualified Education Expense", thereby preserving the tax-free withdrawal status. Special US Savings Bonds purchases which would qualify for tax-free treatment can also be used to fund an account. In each case, investors should proceed very cautiously since all of the aforementioned products are governed by very specialized rules.

Finally, you may rollover (within 60 days) from another existing 529 plan no more frequently than every twelve months. Some form of direct transfer between institutions would probably be the best and easiest route.

Are there any estate or gift tax implications?
For estate and gift tax purposes, contributions are considered completed gifts. Therefore, the first $ (current limit) contributed per person to the beneficiary is exempt from gift taxes. You should be careful to include in that $14,000 amount any other gifts you have made to the beneficiary in the same year. Once the contribution is made, the amount will no longer be includable in the donor's estate. This is one of the very rare circumstances where an asset is not included in your estate, but you still exercise control over its disposition.

A special rule, only applicable to 529 plans, allows for a contribution of up to $65,000 to be made in one year but have it treated as if it were done ratably over five years. This allows contributors to put more money to work earlier to maximize account growth. Effectively, a married couple could contribute $130,000 to each of their children in the first year! The election to spread out the gift must be reported on a gift tax return Form 709 filed each year, although no actual tax would result unless other gifts were made. If the donor dies within the five-year period, the prorata unused portion would be included in the taxable estate. If the beneficiary dies, his or her balance is includable in his or her own estate. There may be a gift tax implication if a beneficiary is changed to someone in a generation below the previous beneficiary, and the balance is over $14,000, but not if the new beneficiary is in the same generation. A generation skipping transfer tax (GST) may also apply in very limited circumstances if the new beneficiary is at least two generations below the original beneficiary. Any such transactions should only be contemplated after discussing these issues with us.

What about Financial Aid?
This is mostly good news. Most states do not count assets held in these plans. Federal programs treat the account as an asset of the parent, resulting in a 5.642% annual Expected Family Contribution (EFC) rather than 35% it if were considered the child's asset. It is extremely difficult to forecast the financial aid landscape for younger children, as well as how easily providers of financial aid will be able to track these assets. A greater consideration is the potential problem from an income standpoint as 529 Plan distributions may be viewed as student income. Current EFC rules require that a student contribute 50% of their income.


Maintaining or distributing from the plan has no effect on the student's ability to use education tax credits such as the HOPE Credit or Lifetime Learning Credit.

What investment choices are available?
All plans use some combination of equity and fixed income portfolios. Most plans have predetermined asset allocations based on the age of the beneficiary that gradually changes to a more conservative mix as he or she gets older and presumably closer to attending school. As the plans have developed, they have included additional investment options for a more aggressive growth. The investment option is selected at the time of application. It is important to note that participants cannot make changes to these choices after application under any circumstances. However, the sponsoring state has the right to change its investment provider without approval of the plan's participants. You could effectively change allocations by rolling over to another plan, as discussed earlier.

There is some concern that most of the plans use an excessively conservative asset allocation, probably because state controllers offices are concerned with liabilities. Plans that do not include the services of a financial professional could suffer from poor allocations or inadequate planning. Fortunately, anyone who desires to shop around can find plans created by experienced asset managers.

Any other minor details?
Bankruptcy issues have been popular lately in the press. It appears that some 529 plans do enjoy limited protection, subject to federal bankruptcy laws and state rules. In addition, legislation is always changing in this area. However, there is a general prohibition against using 529 plan assets as collateral for a loan.

Are there other education funding options available?
Yes, you may contribute to a Coverdell Savings Plan (formerly known as an Education IRA). The good news is that contributions to both 529 Plans and Coverdell Savings Plans are allowable. To contribute the full $2,000 annual contribution per beneficiary, married taxpayers filing a joint return must have modified adjusted gross income less than $190,000. Contributions are phased-out between $190,000 and $220,000. Please remember that contributions may be made to the Coverdell Plans until the federal tax-filing deadline, not including extensions (generally April 15th of the year following the year for which the contribution is made).

Are the qualified expenses the same?
No. Coverdell Savings Plans permit elementary and secondary education expenses as well as post-secondary education expenses.

What other differences are there?
Ownership of assets in the Coverdell Savings Plans for financial aid purposes are most likely that of the student (may vary with the institution).

Conclusions
These new plans offer some great opportunities in saving for college. The 529 package may be the best choice for most people, and especially the more affluent, but the Coverdell Savings Plan may appeal to those wanting to save for elementary or secondary school costs, or to those who want more control over the investment choices.