Sec. 529 Planning with college savings plans - FinancialPlanning

California CPA, Jan-Feb, 2002 by Joyce L. Franklin

The 2001 Tax Act has made qualified tuition savings programs more attractive than ever by allowing tax-free withdrawals from the plans to pay for qualified educational expenses. Qualified tuition programs, also known as Sec. 529 plans, are very beneficial for wealthy and middle-income families.

Sec. 529 college savings plans were established several years ago. Beginning this year, money in a Sec. 529 plan account grows tax-free, as long as the money in the plan is used for qualified higher education expenses, including tuition, fees, books, supplies or room and board.

Assets in the Sec. 529 plan not used for college will be subject to income taxes and the earnings will be subject to a 10 percent penalty, so you may not want to put in more than you know your child will use for college.

Relatives or friends can make annual contributions of up to $10,000 with no tax filing requirements. The plans are a great deal for many people, especially affluent clients, as it allows them to give large gifts, move assets out of their estate, and provide tax-free growth for their heirs benefit.

ADVANTAGES

Some of the advantages of Sec. 529 college savings plans include:

* Withdrawal of earnings and principal from the plans is federal tax-free, as long as the money is used for qualified educational expenses. However, under the sunset provisions, distributions after 2010 are taxable.

* Annual earnings in the account are not taxable.

* Contributions of up to $50,000 per beneficiary may be made in a single year ($100,000 for a couple) without any gift tax implications, although a gift tax return must be filed for gifts over $10,000.

* There are no income limitations on contributions to the plan.

* The donor retains control of the assets, even if the assets are not ultimately used for higher educational expenses.

* Assets can be transferred without a penalty to a family member, including siblings and cousins.

DISADVANTAGES

Some of the disadvantages of Sec. 529 college savings plans include:

* The investment options are limited to the choices available in any state-sponsored program you choose. Most states have a program; California's is called ScholarShare.

* Donors cannot move money between the investment options within a plan. For example, if you choose the 100 percent equity option offered by ScholarShare when your child is two years old, and at age 15 decide that you want a more conservative investment, you will be unable to reduce your risk by switching options. At least one state has requested an IRS Private Letter Ruling asking that participants be allowed to move money between investment options within a state's plan.

Currently, there are three ways to switch investments:

(1) the donor could choose the age-based investment plan, where the investments are riskier (stocks) when a child is very young; as the child approaches college age, bonds and cash automatically are substituted for a portion of the equities;

(2) the donor could switch from one state's plan to another, but the switch can only happen once every 12 months; or

(3) future contributions can be earmarked into a more or less-risky investment option.

* Qualified withdrawals for California residents are taxable.

INVESTMENT OPTIONS

ScholarShare is California's state-sponsored plan managed by TIAA-CREF. California imposes state income tax on withdrawals from any Sec. 529 plan, however, if in the future California conforms to federal tax treatment, it's likely that only the California plan would provide the tax-free benefit for residents. If you like another state's plan better than ScholarShare today, you could invest in the other state's plan now, and move the assets to ScholarShare in the future. The maximum contribution that can be made to a ScholarShare account is $165,886.

ScholarShare currently offers four investment options.

* The Age-Based Asset Allocation Option invests in a combination of stock, bond and money market mutual funds with the percentage of holdings in these investments varying based on the age of the beneficiary. As the child approaches college, the asset allocation is weighted toward fixed income and cash.

* The Equity Option invests in domestic and international stocks.

* The Social Choice Equity Option avoids investing in companies that harm the environment, manufacture weapons, produce alcoholic beverages and tobacco products, produce nuclear energy or engage in gaming or gambling operations.

* The Guaranteed Option guarantees return of principal and a fixed rate of return.

IMPACT ON FINANCIAL AID

Assets in a Sec. 529 plan account are considered for financial aid if the custodian is the parent or if the student is the account owner. However, the financial planning door opens to two opportunities:

* By making a grandparent, aunt or uncle the custodian, the asset does not come into the financial aid calculation.

* Since beneficiaries can be changed among family members, in households with more than one child, contribute to the youngest child's plan first. After the oldest child applies for financial aid and after the financial aid package has been awarded, the income of the student is no longer relevant. The donor can then switch beneficiaries by naming the oldest child. Timing is important and this strategy works best to fund the student's last year of college.