Business Matters: 529 Plan

By Michael D. Raymond

The Smart way to save for college

My daughter danced in a very competitive studio for almost eighteen years. For a long time, dance was her life. A few of her peers went on to begin professional dance careers—Broadway, Disney, ballet companies, commercials, and more. Most, including my daughter, loved the art of dance, but knew a time would come when college books would replace dance lessons. At one point, we thought my daughter would dance on Broadway, but instead she decided to become a CPA [Certified Public Accountant]. That, of course, meant college.

As an advisor to the Rand Council for Aid to Education, and in my capacity as an adjunct professor at Fordham University in New York City, I am aware how much it costs to go to college. As a father of three college graduates, I am quite aware how painful it is to pay for it.

A college education never hurts. According to national statistics, graduates with bachelor degrees may earn up to 75 percent more than those with only a high school diploma. A student with a master’s degree can expect to earn twice as much as that, but it does not come without great expense, and the costs just keep rising. Did you know that tuition at the nation’s public universities rose by an average of ten and one-half percent in 2004, the second largest increase in more than ten years? Last year’s rise, thirteen percent, was the highest ever, said the New York Times in covering the release of the National Report.

Over the course of the last twenty years, the cost of a college education has increased by nearly twice the rate of inflation, as measured by the Consumer Price Index. And it is highly likely that the cost of higher education will continue to rise each year, reports the College Board. For example, a newborn in 2004 can expect to pay over four years about $200,000 to attend Michigan State University eighteen years from now—Columbia University would be over $350,000 according to U.S News Online. Students can borrow money to pay for some of the tuition, but financial aid in the form of loans must be repaid, which places a heavy debt burden on graduates as they embark on their new careers upon graduation. Most parents help any way they can.

How have parents paid for college in the past? Some borrow but that really hurts; some save using the Uniform Gifts to Minor Act (UGMA), which unfortunately gives them no control over how the child spends the money later. Plus, the earnings of the account are taxable each year. Some use the Education IRA, but its low tax-deductible annual contribution limit of $500 restricts the amount needed later. In the end, most parents just use taxable investments when saving. In other words, having no other choice, they dig into their own long-term savings, which can jeopardize their own financial security later. Now there is a new, more powerful strategy.

Created in 1996 by Section 529 of the Internal Revenue Code, a 529 plan is a qualified state-sponsored program for tax-deferred college savings. The plan can be used to pay for education costs at any eligible college, university or graduate school in the US and some foreign institutions. Under current law, a bill exempts 529 earnings from federal income taxes if the savings comes out to pay for college expense. Parents, grandparents, and friends, can put huge sums of money (up to $294,000 in some cases) into 529 accounts. If you don’t have huge sums to start, you can also open an account with minimums as low as $250 (with subsequent contributions of at least $50).

Can the child just walk away with these assets? The answer is no. Unlike a UGMA account, parents become the owners. Anyone—a child, grandchild, niece, nephew, friend or even the parent—can be a beneficiary provided the student attends an accredited two- or four-year college, university, vocational, professional school, or graduate school. If the designated child does not attend college, the owner simply designates another “family member”of the original beneficiary as the new one. And there are no age limits. There is no time limit associated with using the assets. Therefore, in a 529 account, there is potential for significant long-term tax-free growth, and special gift and estate tax treatment. Some states even offer additional favorable tax treatment to their residents.

There is one caveat. Parents may withdraw the money, of course, but if assets are withdrawn for any reason other than for college expenses, earnings will be subject to state and federal income taxes as well as a federally mandated ten percent penalty on the earnings portion of the distribution. There are a few instances in which the ten percent penalty will not apply: upon the death, permanent disability, or mental incapacity of the beneficiary, or if the beneficiary receives a scholarship. “Students receiving scholarships” will allow the owner to withdraw up to the amount of the scholarship without penalty, and with earnings taxed only at the account owner’s rate.

Make sure any money you put into these accounts will be used for family members with a good likelihood of attending college. For those who do, the 529 program provides a preferred strategy over all the old college saving vehicles we have all used in the past.

The 529 plans are state-sponsored investment programs and there is no guarantee by the issuing municipality or any government agency. Under a “sunset provision” certain federal tax benefits associated with 529 plans are scheduled to expire on December 31, 2010, in the absence of re-enactment. Consider the potential benefits of your own state’s plan (if available) before considering another state’s plan since there may be tax benefits to plans offered by your resident state. As with all tax–related decisions, consult with your tax advisor. Please note that assets in a 529 plan could impact the beneficiary’s ability to qualify for grants and student loans. Annual asset charges for a 529 plan may be higher than corresponding share classes of underlying mutual funds.

Municipal fund securities are sold by offering statement, which is available from your registered representative. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about municipal fund securities, obtain an offering statement and read it carefully before you invest. Investment return and principal value will fluctuate with changes in market conditions such that shares may be worth more or less than original cost when redeemed. Diversification cannot eliminate the risk of investment losses.

Information provided in this article is not specific investment advice, a guarantee of performance, or a recommendation. This material is not intended as tax advice. Investors should consult with an appropriate professional regarding their own personal situation.

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