When it comes to college savings plans – as it does 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 college.
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.
Section 529 plans – named after the IRS code that created them – are state-sponsored college savings plans that allow flexibility in choosing a school and the opportunity for late starters to make sizable investments while reaping tax breaks.
The 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, which may be based on your risk tolerance or determined by your child's age. In general, when asset allocation is based on age, it 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 often exceed $200,000, and offer some flexibility on when you can contribute. 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.
Once your child reaches college age, the account owner may withdraw money from the account to pay for qualified higher education expenses. Withdrawals are tax free if used to pay for qualified education expenses. Nonqualified withdrawals will be subject to a 10 percent penalty in addition to ordinary income taxes.
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.
There are no income thresholds and typically no annual contribution limits, although annual contributions of more than $13,000 ($26,000 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 $65,000 per beneficiary, without triggering the federal gift tax.
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, the 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.savingfor college.com.
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 beginning college. Although the firms that manage Section 529 plans use less-risky asset allocations to reduce risk as your child nears college, 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 college expenses. Penalties are imposed if withdrawals are not used for qualified higher education expenses.
Section 529 plans are just one of the options you have for college savings. If you're starting early on saving for college, you might consider a prepaid tuition plan that 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.
Coverdell Education Savings Accounts (formerly called Education IRAs) allow you to set aside money each year toward a child's education. The contribution limit is $2,000. Withdrawals for qualified higher education expenses are tax free, and account balances can be transferred to siblings without any tax consequences, so long as it is done prior to the previous beneficiary's 30th birthday and the new beneficiary is under the age of 30.
While tax benefits make these accounts attractive, the low contribution limit may not provide enough money to pay for college. Unlike state-sponsored plans, income limits apply for eligibility. Only single filers with incomes of less than $110,000 and joint filers with incomes of less than $220,000 are eligible.
(Charles Sims Jr. is president/ CEO of The Sims Financial Group. Contact him at 901-682-2410 or visit www. SimsFinancialGroup.com.)