An education is one of the best investments you can make for
your child's future. But the high cost of education may alarm you
-- especially if you've waited too long to begin saving. For
example, a Coverdell Education Savings Account (formerly referred
to as the Education IRA), with its annual contribution limit of
$2,000, won't offer much help if your child is already in high
school. And prepaid tuition plans are attractive, but only if your
child is willing to attend a school that participates in the
plan.
Fortunately, there's another option. Created in 1996,
state-sponsored savings plans (or Section 529 plans, named after
the IRS code that created them) allow flexibility in choosing a
school and the opportunity for late starters to make sizable
investments while reaping tax breaks.
How the Plans Work
Section 529 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
determined by your child's age. In general, the asset allocation
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 they typically exceed $200,000 and offer some
flexibility on when you can contribute. In addition, there are no
income thresholds and typically no annual contribution limits,
although annual contributions of more than $15,000 ($30,000 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
$75,000 per beneficiary, without potentially triggering the federal
gift tax. 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. Please consult with your tax
professional concerning your situation.
Section 529 plans may be used to fund qualified expenses at
post-secondary educational institutions, and starting in 2018, up
to $10,000 per year may be used to fund expenses for K-12
educational expenses as well. Assuming that you have followed the
plan's rules, there will be no penalties (nonqualified withdrawals
will be subject to a 10% additional federal tax in addition to
ordinary income taxes). And qualified withdrawals are tax free. 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.
Pros and Cons
Flexibility in contributions and choice are the biggest
advantages of Section 529 plans over other tax-deferred education
savings vehicles. 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, these 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.savingforcollege.com. This website includes graphical
ratings that compare the plans and links to plans that have
websites.
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 ready to use the funds.
Although the firms that manage Section 529 plans use less-risky
asset allocations to reduce risk as your child grows older, 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 education expenses. Additional federal taxes are
imposed if withdrawals are not used for qualified education
expenses (generally 10% on earnings only).
Choosing the Plan That's Best for Your Family
Section 529 plans are just one of the options you have for
education savings. They offer a great deal of flexibility in
exchange for a higher level of investment risk. If you're getting a
late start or if your child is unsure of which school he or she
wishes to attend, a Section 529 plan may be your best choice.
But if you're starting early on saving for college, you might
consider a prepaid tuition plan. This plan 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.
As 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 using the
funds. 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 professional to find the plan that
best suits your needs.
