Last updated on April 13, 2004
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SAVING FOR COLLEGE
529 Plan FAQs
by Cameron Huddleston & Kimberly Lankford Since Kiplinger's first wrote about tax law changes concerning state-sponsored college-savings plans (see "Tax Breaks for College Savers") readers have asked quite a few questions about how to pick the best plan, how to choose between a Coverdell Education Savings Account and a 529, plan and how to enroll. This quick guide should help. But if you need more answers, post your questions in the Kiplinger.com Community forums.
Is a state 529 plan the way to go?
Which state has the best plan?
How do I enroll?
Can I roll savings bonds in to a 529 plan?
Can I transfer custodial account funds to a 529 plan?
Can I write-off a 529 contribution on my state taxes?
Can I split my contributions?
Who controls the plan?
Can I switch plans?
Can the money be used at a foreign college?
Is a state 529 plan the way to go?
When the first Bush tax law took effect in 2002, state-sponsored college savings plans -- otherwise known as 529 plans -- became the hands-down best choice for your college dollars. However, times have changed.
As the law currently stands, withdrawals for qualifying education expenses are tax-free, but only through 2010. If your students don't complete their degrees by then, earnings from future withdrawals would add to your income tax bill. Congress still has plenty of time to make the benefit permanent, though. Earnings in 529 plans would remain tax-deferred.
Tax law changes in 2003 also make other savings vehicles, such as custodial accounts, more appealing.
That's because the 2003 tax law reduced the rate on dividends and capital gains to as little as 5% for those in the lowest tax bracket. Because most children would fall into this bracket, the tax burden on accounts held in their names would be minimal.
Coverdell education savings accounts also have become more appealing recently because they are now treated as parental assets (not a student's) in college financial-aid formulas -- improving a family's chance of receiving financial aid.
However, there still are plenty of reasons to consider 529 plans. Here's why:
- They're simple. State 529 plans are easy. Choose an investment option and make contributions and the plan does the rest. Sit back while the state or a third party, such as an investment firm, manages your funds.
- Contributions may be state-tax deductible.
Twenty-four states and the District of Columbia allow you to deduct some or all of your contributions. Rules vary, so check with your state for more details.
- They're portable. Depending on the state, you can choose from a number of different investing options. You also can switch investment tracks within the plan once a year. And if you don't like your state's plan, shop around. Plans are open to residents and nonresidents alike. You also can roll your savings into another state's plan without penalty.
- There are no set annual contribution or income limits. Contribution limits vary by state, and some states do not limit contributions at all -- a good option for grandparents looking to transfer assets through estate planning.
Don't think of ESAs and Section 529 plans as mutually exclusive. If you have the money, consider funding both. ESAs also can be spent on private school tuition or other qualified educational expenses.
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Which state has the best plan?
If you live in one of the
24 states and District of Columbia that offer a deductible contribution, there's probably no need to look further. Your savings on taxes likely will overcome any shortcomings your state's 529 plan might have.
If you don't get a deduction, then consider these top picks:
What makes these state plans so good? Low expenses and plenty of investing options, two things you should focus on when making your choice.
Expenses. Annual fees, as well as management and maintenance expenses, can eat into returns and can vary greatly from state to state. If you choose to open your account through a broker, versus directly through the state, these fees and charges may be even higher. Also keep in mind that nonresidents typically pay higher fees than residents. For example, Kansas has a $10 annual maintenance fee for residents, but the same fee is $40 for nonresidents (asset-management expenses range from 0.86% to 1.34%). Washington, on the other hand, charges only an enrollment fee of $50.
Also, keep in mind that several states penalize non-education withdrawals, usually 10% of earnings.
Investment choices. Most states offer three or more investment tracks that range from conservative to aggressive. One usually is an age-based portfolio that invests mainly in stocks while a child is young then shifts to bonds and money-market funds the closer college is on the horizon.
When choosing a track, consider whether it reflects your risk tolerance. If you wouldn't invest entirely in stocks in a retirement account, you probably shouldn't do so for a college savings account, either.
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How do I enroll?
This is the easy part. While some plans restrict enrollment to specific months, most are open year-round. Enrollment can be as easy as downloading a form from the Internet, filling it out and mailing it in. Some states, such as Kansas, actually let you open an account completely online.
You open an account with as little as $25 or $50. And you can pay by check or set up monthly contributions through payroll deduction or automatic withdrawal from a designated bank account.
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Can I roll savings bonds in to a 529 plan?
Yes, and there is no tax penalty.
Cash out the bonds and reinvest the money in the savings plan. At tax time you'll want to file IRS Form 8815 to exclude the savings bond interest from income taxes. You also must make sure that the savings-bond rollover conforms to all the rules and that your income doesn't exceed the limit. Visit the Bureau of Public Debt Web site for more details.
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Can I transfer custodial account funds to a 529 plan?
Most 529 plans allow such a transfer, but there are a few special rules. Money you put into the kids' custodial accounts was an irrevocable gift, and moving it to a 529 account doesn't change that fact. The money can never be shifted to another beneficiary, for example, and your children will control it when they reach the age of majority, either 18 or 21, depending on state law. New money put into a separate account in the same 529 plan still can be controlled by the parents and shifted to another beneficiary if the child for whom the account is intended decides not to go to college.
The distinction between custodial-account money shifted to a 529 plan and other contributions is a good reason to separate accounts. College-savings plans accept only cash deposits, so you'll have to sell the stock, mutual funds or other investments from the custodial account -- and pay capital-gains taxes on any profits -- to shift the money.
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Can I write-off a 529 contribution on my state taxes?
That depends on where you live. The states below let residents write off contributions to the state's own plan.
In most cases, it's the child who gets the deduction when shifting custodial-account money into a 529. Remember: It's the kid's money. But a few states may allow parents to claim the write-off, says Joseph Hurley, author of The Best Way to Save for College: A Complete Guide to 529 Plans. For each state's deductibility rules, visit Hurley's Web site, Savingforcollege.com.
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Can I split my contributions?
There's no problem splitting your contributions among different states' plans. But check the deductibility rules carefully. Some states let each spouse take an income-tax deduction for contributions, so you might double your deduction by opening up two accounts in your own state before moving on to another one. Your claim-the-deduction-then-move-the-money strategy might work, Hurley says, but some states "recapture" the tax savings. Again, you'll have to check with the specific plan's administrator.
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Who controls the plan?
Each account has an owner -- or joint owners -- and that person controls the assets, regardless of how many people contribute. The owner doesn't have to be a parent.
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Can I switch plans?
New rules make it much easier to shift from one state's plan to another. In the past, this was allowed only when changing the beneficiary of the account. Now you can move money as often as once a year for any reason.
Contact the plan you'd like to switch into to get the forms you'll need to make the transfer. Because many states continue to improve their plans, it's smart to check out the options every year or so.
Can the money be used at a foreign college?
You can use the money at 771 foreign colleges, including the University of Toronto, McGill in Montreal and many other Canadian schools. If U.S. students at the school qualify for federal financial aid, you can use 529-plan or ESA money to pay the bills without worrying that you'll lose any of the tax benefits. Check the Department of Education's Web site for a list of qualifying schools. | 
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