College savings plans – some options
email@example.com | 10/18/2012, 12:16 p.m.
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.