529 Plans Offers Parents College-Saving Options for Children

By Chuck Toth and Shirley Quackenbush
November 2009

Since they were created by Congress 10 years ago, 529 plans have been an attractive way to boost college savings for a child or grandchild. This year, changes in the tax code make them look even better.

529 plans, so called because they were authorized by Section 529 of the Internal Revenue Code, allow investment earnings to grow free from federal and, in most cases, state income taxes for the life of the account. The Internal Revenue Service does not tax 529 distributions, nor do many state governments, as long as they are used for qualified higher education expenses such as tuition, room and board, mandatory fees, books, and even computers.

Investment Options in 50 States

As of 2009, the amount of money donors may contribute has been raised to $13,000 per person—or $26,000 per couple filing a joint return—per child each year. All 50 states and the District of Columbia sponsor 529 plans.  Some states, in fact, offer more than one plan, giving a range of investment options that include stock mutual funds, bond mutual funds, money market funds and age-based portfolios that automatically shift to a more conservative balance of investments as the beneficiary gets closer to college age.

Those assets may be used to pay for education expenses at any accredited college or university in the United States, no matter which state’s plan you choose to participate in. Residents of certain states have an incentive to invest with their home-state plan since they may be able to deduct annual contributions from that state’s income tax. For example, New York state residents may deduct up to $5,000 per person—$10,000 per couple—per year for a contribution to their state’s plan. Contributions by residents to New Mexico’s plan are fully deductible.

Additional Benefits

529 plans have an extra benefit for parents who have already been saving for a child’s education through a custodial account under the Uniform Gift/Transfer to Minors Act (UGMA/UTMA). Historically, these custodial accounts were attractive because when the child took control of the money to pay for education expenses—at age 18 or 21 depending on state law—the distributions were taxed at the child’s tax rate. Beginning in 2009, however, these distributions are taxed at the parents’ higher tax rate for full-time students through the age of 23 for any investment income greater than $1,800.

You can maintain the tax efficiency of UGMA/UTMA accounts by transferring their assets to a “custodial” 529 plan before the end of the year. The transferred funds still belong to the minor child, who is allowed to take control of the money when he or she reaches the age mandated by state law. Even better, student-owned 529 accounts do not have to be reported on the federal student aid application and thus have no impact on a child’s eligibility for federal financial aid.

Other Items to Note

Taxes on capital gains will likely increase after 2010, when current tax rates sunset. For this reason, transferring UTMA/UGMA assets now will have the smallest tax consequence. Besides improving your child’s chances of receiving federal financial aid, putting a 529 wrapper around those assets helps ensure that he or she will use those savings for college.

Because only cash may be contributed to a 529 plan, UTMA/UGMA assets must be liquidated to make the transfer, potentially triggering capital gains. Depending on the child’s age, the benefits of tax-free growth over a short time period may not outweigh the tax consequences of liquidating the UGMA/UTMA account. Talk to your financial advisor and your tax advisors to determine if this strategy is suitable for you.

In addition to tax-deductible contributions and tax-free withdrawals, noncustodial 529 plans provide a valuable tool for estate planning. You have the option of “front-loading” five years worth of contributions in a single year without incurring gift taxes.  An individual may contribute up to $65,000 per beneficiary in one year, or $130,000 for a couple filing a joint return.  If you donate the full amount, you use up your gift tax exemption for the next five years. Any other gift given to that same individual during those years will be taxed as a gift.

Explore Your Alternatives

For all the advantages of 529s, there are a few key caveats to consider before committing the funds. The investment options are limited, and account holders are permitted to change their options only once a year, restricting your ability to respond to market changes. Of course, there is always the risk that investments in a 529 plan can go down in value. Front-loading now when asset values are low may yield superior returns for a child who won’t be entering college for 10 or 15 years, but you may prefer to explore more conservative options for older children. Talk to a financial advisor to find the best college-savings options for your situation.

Chuck Toth is director of education savings at Merrill Lynch in New York City, N.Y. Shirley Quackenbush is vice president and wealth management advisor at Merrill Lynch in Newport Beach, Calif.