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In 1996 Congress passed legislation which established an effective way for individuals and couples to set aside funds for college for their children, grandchildren, and others, with significant tax benefits. The plan has been greatly liberalized by amendments through 2001, effective in 2002.
The plan allows individuals to set aside up to $55,000 at one time without gift tax, to allow the earnings and appreciation to grow tax-free, to control the distribution of the funds, and to allow the funds to be withdrawn from the plan for all post-secondary educational costs without paying any income tax on the distributions, including the earnings and appreciation which have accumulated in the plan. This type of plan is referred to by the Internal Revenue Code section which created it and is known as a "529 College Savings Plan" or a "529 Plan."
Each state in the United States is eligible to sponsor this type of plan, one plan per state. A contributor does not have to make a contribution to the plan in his or her state, but can contribute to any plan offered by any state. Most, but not all states, offer these plans.
Each state usually offers several choices of investments, generally in collaboration with a large investment firm, such as T. Rowe Price, Vanguard, and others. Contributions can only be in cash and the contributor cannot direct the investments, directly or indirectly, and may not pledge the funds as collateral or security for any loan. The contributor can designate investment choices if the particular plan offers this provision and can change investment options, if allowed by the plan, annually.
Fees usually include an annual account maintenance fee, an annual program administration fee, and the investment management fee collected by the fund manager, such as a mutual fund.
Investment options vary widely depending upon the plan. A contributor may transfer an account from one state's 529 plan to another state's plan.
Any United States citizen or permanent United States resident at least 18 years of age can contribute to an account on behalf of any beneficiary. There are no income tax benefits for making the contribution. However, there are also no limits on income by a contributor making a contribution. Contributions can be made to an account for a specific beneficiary until the account reaches a value of $250,000. The account can exceed this amount by future income and growth, but no future contributions can be made for that beneficiary once the account has reached a value of $250,000.
A contributor can transfer up to $55,000 at one time for one beneficiary without exceeding the gift tax limitations. This gift is considered made for the current and the next four years, using the annual exemption for that beneficiary (the annual gift tax exemption increased to $11,000/year/donee in 2002). A contributor cannot make any other gifts using his or her annual exemption for that beneficiary during this five year period. If a contributor dies before the end of the five year period, his or her estate includes the balance of the remaining contribution in his or her taxable estate for estate tax purposes.
For example, John Doe contributes $55,000 to a 529 Plan for his grandson in 2004. He dies in 2006. Since he used his annual gift tax exemption of $11,000 each for 2004, 2005, and 2006, $33,000 of his contribution would be exempt and $22,000 would be included in his taxable estate for federal estate tax purposes. Earnings and appreciation are ignored. If John Doe lived until 2008, all of the contributed funds would be excluded from his estate at death.
Husband and wife can each make a $55,000 single gift for a child or grandchild. If a couple has sufficient assets and wants to fund this for four grandchildren, they can make a one-time contribution of $440,000 for their four grandchildren-$55,000 from each of them for each of their four grandchildren. If the grandparents live five years after making the contribution, none of this $440,000 will be includable in their taxable estate for federal estate tax purposes.
Most plans require a minimum initial contribution of $2,000-$3,000. But additions to the plan can be made at any time (subject to a minimum amount).
It is possible to transfer from one 529 Savings Plan to another at any time. You can also transfer funds from a Uniform Gift to Minors Account or Uniform Transfer to Minors Account to a 529 Savings Plan, although it could possibly be a gift and should not be done without advice.
The account owner, who is also referred to as the contributor, controls the account in terms of directing payments made from the account to the named beneficiary. No payments are made automatically or at the request of the beneficiary. In the event the account owner dies, a named successor must take over the account and, if none is named, the beneficiary can name a new account owner. A beneficiary cannot be the successor account owner.
Any permanent United States resident can be a beneficiary of a 529 College Savings Plan. There are no age limitations so an adult child can be a beneficiary to fund adult education (complete college, postgraduate degree, law school, etc.).
Funds in the account can be used to pay for tuition, room and board (with limitations), books, supplies, and equipment required for enrollment or attendance at any eligible post secondary school in the United States or abroad.
To avoid income taxation a beneficiary must use Plan funds to pay qualified expenses at any eligible college or graduate school in the United States. Qualified expenses include tuition, fees, books, supplies and equipment required for attendance or enrollment at the educational institution. It also includes room and board provided the student is attending at least half time.
The contributor of the account can change the beneficiary at any time. The new beneficiary has to be related to the old beneficiary by a blood or marriage relationship, such as child, stepchild, sibling, niece or nephew, parent, aunt or uncle, spouse of either beneficiary, or spouse of any of the above.
If the designated beneficiary dies, the contributor may withdraw the funds in the account without penalty, but subject to income tax on the earnings.
The principal placed in the account is never subject to income tax; only the earnings and appreciation are taxable. All funds held in the account grow income tax free.
Any earnings portion of a distribution is taxed to the beneficiary as ordinary income. However, if the income is used for college expenses, as listed above, it is exempt from income tax. If the funds are not used for qualified educational expenses, the earnings portion is taxed to the beneficiary as ordinary income and there also is a 10% penalty on the earnings distributed. The penalty is waived if the beneficiary is deceased or disabled and is also waived if the beneficiary receives a scholarship and withdraws funds equal to the amount of the scholarship.
If the account owner takes the money back, which is allowed, he or she pays income tax on the earnings and a penalty of 10% on those earnings.
Various states tax the plan benefits differently. Some states allow an income tax deduction for funds contributed to these plans. Some states do not tax the benefits paid if used for qualified educational expenses.
Other states do not allow any income tax deduction for contributions to the plan and fully tax all earnings on distribution when paid, whether they are for qualified educational benefits or not.
California does not allow an income tax deduction for contributions and taxes the earnings, when distributed, as ordinary income.
This type of plan is very flexible and allows individuals to set aside large sums of money for future educational expenses of relatives such as children and grandchildren. Before making any contribution, a person should fully explore the options and advantages and disadvantages with a tax professional and investment advisor.
© Milton Berry Scott, A Professional Corporation, 2002-2005