Section 529 plans
can be powerful college savings tools, but you need to understand how your plan
works before you can take full advantage of it. Among other things, this means
becoming familiar with the finer points of contributions and withdrawals. A little
knowledge could save you money and maximize your chances of reaching the
educational goals you've set for your children. But keep in mind that all
investing involves risk, including the possible loss of principal, and there
can be no assurance that any investment strategy will be successful.
HOW MUCH CAN YOU CONTRIBUTE?
To qualify as a 529 plan under
federal rules, a state program must not accept contributions in excess of the
anticipated cost of a beneficiary's qualified education expenses. At one time,
this meant five years of tuition, fees, and room and board at the costliest
college under the plan, pursuant to the federal government's "safe
harbor" guideline. Now, however, states are interpreting this guideline
more broadly, revising their limits to reflect the cost of attending the most
expensive schools in the country and including the cost of graduate school. As
a result, most states have contribution limits of $300,000 and up (and most
states will raise their limits each year to keep up with rising college costs).
A state's limit will apply to
either kind of 529 plan: prepaid tuition plan or college savings plan. For a
prepaid tuition plan, the state's limit is a limit on the total contributions.
For example, if the state's limit is $300,000, you can't contribute more than
$300,000. On the other hand, a college savings plan limits the value of the
account for a beneficiary. When the value of the account (including
contributions and investment earnings) reaches the state's limit, no more
contributions will be accepted. For example, assume the state's limit is $300,000.
If you contribute $250,000 and the account has $50,000 of earnings, you won't
be able to contribute anymore--the total value of the account has reached the
$300,000 limit.
These limits are per beneficiary,
so if you and your mother each set up an account for your child in the same
plan, your combined contributions can't exceed the plan limit. If you have
accounts in more than one state, ask each plan's administrator if contributions
to other plans count against the state's maximum. Some plans may also have a
contribution limit, both initially and each year.
Note:
Generally, contribution limits don't cross state lines. Contributions made to
one state's 529 plan don't count toward the lifetime contribution limit in
another state. But check the rules of your state's plan to find out if that
plan takes contributions from other states' plans into consideration when
determining if the lifetime contribution limit has been reached.
HOW LITTLE CAN YOU START OFF
WITH?
Some plans have minimum
contribution requirements. This could mean one or more of the following: (1)
you have to make a minimum opening deposit when you open your account, (2) each
of your contributions has to be at least a certain amount, or (3) you have to
contribute at least a certain amount every year. But some plans may waive or
lower their minimums (e.g., the opening deposit) if you set up your account for
automatic payroll deductions or bank-account debits. Some will also waive fees
if you set up such an arrangement. (A growing number of companies are letting
their employees contribute to college savings plans via payroll deduction.)
Like contribution limits, minimums vary by plan, so be sure to ask your plan
administrator.
KNOW YOUR OTHER CONTRIBUTION
RULES
Here are a few other basic rules
that apply to most 529 plans:
Only cash contributions are
accepted (e.g., checks, money orders, credit card payments). You can't
contribute stocks, bonds, mutual funds, and the like. If you have money tied up
in such assets and would like to invest that money in a 529 plan, you must
liquidate the assets first.
Contributions may be made by
virtually anyone (e.g., your parents, siblings, friends). Just because you're
the account owner doesn't mean you're the only one who's allowed to contribute
to the account.
Contributions generally may not
be directed toward particular investments of your choice. However, most college
savings plans offer several different investment portfolios, and many let you
choose one or more portfolios to invest your contributions. You make this
choice at the time you make your contribution. Some states have also added two
opportunities to change your investment choice. Savings plans in these states
let you change your investment choice when you change the beneficiary of the
account. These plans let you change the investment portfolio once each calendar
year, as well.
MAXIMIZING YOUR CONTRIBUTIONS
Although 529 plans are
tax-advantaged vehicles, there's really no way to time your contributions to
minimize federal taxes. (If your state offers a generous income tax deduction
for contributing to its plan, however, consider contributing as much as
possible in your high-income years.) But there may be simple strategies you can
use to get the most out of your contributions. For example, investing up to
your plan's annual limit every year may help maximize total contributions.
Also, a contribution of $14,000 a year or less qualifies for the annual federal
gift tax exclusion. And under special rules unique to 529 plans, you can gift a
lump sum of up to $70,000 ($140,000 for joint gifts) and avoid federal gift
tax, provided you make an election to spread the gift evenly over five years..
This is a valuable strategy if you wish to remove assets from your taxable
estate.
LUMP-SUM VS. PERIODIC
CONTRIBUTIONS
A common question is whether to
fund a 529 plan gradually over time, or with a lump sum. The lump sum would
seem to be better because 529 plan earnings grow tax deferred--the sooner you
put money in, the sooner you can start to generate earnings. Investing a lump
sum may also save you fees over the long run. But the lump sum may have
unwanted gift tax consequences, and your opportunities to change an investment
portfolio are limited. Gradual investing may let you easily direct future
contributions to other portfolios in the plan.
QUALIFIED WITHDRAWALS ARE TAX
FREE
Withdrawals from a 529 plan that
are used to pay qualified higher education expenses are completely free from
federal income tax and may also be exempt from state income tax. Qualified
higher education expenses generally include tuition, fees, books, supplies, and
equipment required for enrollment or attendance at an "eligible"
educational institution. In addition, the definition includes a limited amount
of room-and-board expenses for students attending college on at least a
half-time basis. The definition does not currently include the cost of
transportation or personal expenses.
Note:
A 529 plan must have a way to make sure that a withdrawal is really used for
qualified education expenses. Many plans require that the college be paid
directly for education expenses; others will prepay or reimburse the
beneficiary for such expenses (receipts or other proof may be required).
BEWARE OF NONQUALIFIED
WITHDRAWALS
By now, you can probably guess
what a nonqualified withdrawal is. Basically, it's any withdrawal that's not
used for qualified higher education expenses. For example, if you take money
from your account to buy your son a new Porsche, that's a nonqualified withdrawal.
Even if you take money out for medical bills or other necessary expenses,
you're still making a nonqualified withdrawal.
One reason not to make this type
of withdrawal is to avoid depleting your college fund. Another compelling
reason is that these withdrawals don't enjoy tax-favored treatment. The
earnings part of a nonqualified withdrawal will be subject to federal income
tax, and the tax will typically be assessed at the account owner's rate, not at
the beneficiary's rate. Plus, the earnings part of a nonqualified withdrawal
will be subject to a 10 percent federal penalty, and possibly a state penalty
too.
IS TIMING WITHDRAWALS IMPORTANT?
As account owner, you can decide
when to withdraw funds from your 529 plan and how much to take out--and there
are ways to time your withdrawals for maximum advantage. It's important to
coordinate your withdrawals with the education tax credits. That's because the
tuition that's used to generate a credit may reduce your available pool of
qualified education expenses. A financial aid or tax professional can help you
sort this out to ensure that you get the best overall results. It's also a good
idea to wait as long as possible to withdraw from the plan. The longer the
money stays in the plan, the more time it has to grow tax deferred.
Note:
Investors should consider the investment objectives, risks, charges, and
expenses associated with 529 plans before investing. More information about
specific 529 plans is available in each issuer's official statement, which
should be read carefully before investing. Also, before investing, consider
whether your state offers a 529 plan that provides residents with favorable
state tax benefits.
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