Chapter 5

Laying Down the Basics of Section 529 Plans

In This Chapter

Looking at the parts of the plan

Checking out the qualifying criteria

Making contributions to the plan

Choosing a type of 529 plan

Even though you probably have come across the terms “Section 529 plan” and “qualified tuition program” (QTP, for short) many times, you still may not really know what they mean. Everyone seems to be selling one, so these plans clearly must be the best thing since sliced bread and bologna, right?

In fact, Section 529 refers to a part of the Internal Revenue Code (how’s that for sexy?) regarding the rules and regulations concerning qualified tuition programs. And, despite the fact that the phrases may have become so familiar that the words just drip easily off your tongue, these rules are quite complex and must be followed exactly.

Qualified tuition programs covered under Section 529 of the Internal Revenue Code are, quite simply, programs that allow you to save money or purchase tuition credits for future college expenses for a specific beneficiary in an account that is administered either by the state (yours or any other — some states allow residents of other states to participate in their plans) or by a specific college or university. You may see them called either Section 529 plans or qualified tuition programs — they’re one and the same.

In this chapter, you find out what qualified tuition programs under Section 529 of the Internal Revenue Code are, how they work, why they’re great, where they could be improved, and how they may be changing in the future.

Discovering the Parts of 529 Plans

Although you may come across many variations of 529 plans, all have the following component parts:

The plan owner: The plan owner is the person who sets up the plan (and who, presumably, makes contributions into it, although other people can make contributions into a plan that isn’t their own). You must be at least 18 years old to be a plan owner, and depending on the plan that you’re interested in starting, you may need to be a resident of the plan state.

The designated beneficiary: The designated beneficiary is the potential student for whom the plan owner (who doesn’t need to be related to the designated beneficiary in any way) intends to provide a postsecondary education. The plan owner names this person when he or she sets up the account. You can change the designated beneficiary over the lifetime of the account, but the account must always have a designated beneficiary. Like the plan owner, the beneficiary may have to be a resident of the plan state to qualify as a designated beneficiary.

With any luck, the person that you name as your designated beneficiary will grow up, in time, to also be a qualified student (see the “Making sure your student qualifies” section, later in this chapter).

The plan administrator: The plan administrator is the state or educational institution under whose auspices the plan exists. In many cases, especially in prepaid tuition plans, the plan administrator is also the plan manager (see the next item in this list). The plan administrator lays out the rules that are specific to that plan, including how much may be contributed, what sorts of investments are allowed, when contributions may be made, and whether plans are open to only resident owners and beneficiaries, or if all may participate.

Plan manager: Many Section 529 plans (particularly savings plans) are invested in a variety of mutual funds. Because states aren’t in the mutual fund business, they farm this work out to mutual fund companies. These companies (and states that actively manage investments) are the plan managers; they’re responsible for the actual investing of your money.

Figuring Out the Qualifying Criteria

Section 529 plans seem to be wrapped in qualification after qualification, but don’t allow these endless lists of criteria discourage you from using 529 plans. Instead, check out how I break down those lists of qualifications so that you can easily identify whether your plan, your student, and your student’s expenses meet the myriad criteria associated with 529 plans.

Funding for the professional student

You may have already investigated one or more Section 529 plans and discovered the dollar limitation that is built into each state’s plan. The limits are very high, especially for the Section 529 savings plans (which can reach toward $300,000 in a single plan, depending on what state’s plan you use). But if your designated beneficiary is headed for great things — such as years of graduate or professional education beyond a bachelor’s degree — the limits built into a single state’s Section 529 plan may not be enough to cover your costs.

If you suspect that perhaps your son or daughter is heading for medical or law school after college and nothing but an Ivy League school will do, you can fund Section 529 plans in more than one state, even if your total contributions across all plans, regardless of state, equal more than the limit for any single state. Remember, the wording in Section 529 is specifically vague, and the limits are imposed at the state level, not the federal. So long as you do not fund plans in excess of what your designated beneficiary will use during his or her postsecondary education, having more than one plan in more than one state is perfectly okay.

Making sure your plan qualifies

In order for a Section 529 plan to qualify under the IRS’s rules, it must meet the following criteria:

Contributions may be made only in cash, including checks, money orders, or payroll deductions, but not in stocks, bonds, or real estate.

After a contribution is made into a specific plan, you may not direct the investments. You may, however, change plans once each year.

You may not pledge the value of the account as security against any sort of loan.

The plan or program in which you invest must provide each designated beneficiary a separate accounting.

You can’t contribute more into an account, or group of accounts, for the benefit of a single designated beneficiary than the beneficiary will use in the payment of qualified higher education expenses. You have to try to estimate this amount.

When you make a contribution to a Section 529 plan, you’re not allowed any federal income tax deduction for the amount of your contribution (unlike many sorts of retirement plans, which defer income tax not only on the accrued earnings in the account but also on your contributions). Depending on what state you live in (and if you use its plan), you may get a current state income tax deduction for part or all of your contribution each year.

After your money is safely tied up in a Section 529 plan, interest that you earn on it isn’t taxed until distributions (amounts of money you take out of the plan to pay your student’s expenses) are made to your designated beneficiary. And, if you use distributions from these plans to pay the qualified education expenses of a student at an eligible educational institution (these are the IRS’s words, not mine), accrued earnings generally aren’t taxed at all (see the exceptions outlined in the section “Exceptions to tax-free distribution rules,” later in this chapter).

In other words, a Section 529 plan allows you to save for college, and it exempts or defers income tax on the accrued earnings until the designated beneficiary begins taking distributions from the plan.

At this point, you may be thinking that the only educational institutions that these plans are qualified to pay for are colleges and universities. Not true. Qualified institutions include all postsecondary schools that are eligible to participate in U.S. Department of Education financial aid programs, including many vocational and technical schools, community colleges, and even some apprenticeship programs. Eligible institutions don’t need to be located in the United States; many foreign colleges and universities qualify. The standard here is that the schools must be eligible; they don’t actually have to participate in these financial aid programs. Check with the institutions you or your student are interested in to be sure that they qualify.

Making sure your student qualifies

Strangely enough, the things you think of when the phrase “qualified student” comes to mind (grades, commitment, drive, and so on) have absolutely nothing to do with the IRS’s definition. For the purpose of Section 529 plans, a qualified student must meet the following criteria:

He or she needs to be the original designated beneficiary of the plan or, in the case of a tax-free plan rollover (see the section “Transferring and rolling over plans,” later in this chapter) to another beneficiary, must be a member of the same family as the original beneficiary in one of these listed relationships:

• Spouse

• Child, grandchild, or great-grandchild (a lineal descendent)

• Stepchild, stepmother, or stepfather (but no stepgrandchildren)

• Brother, sister, stepbrother, or stepsister

• Father, mother, or grandparents (a lineal ancestor)

• Niece or nephew

• Brother or sister of your mother or father

• First cousin

• An in-law, either mother, father, sister, brother, son, or daughter

• Husband or wife of any person on this list

He or she must actually be an enrolled student at a qualified educational institution.

Making sure expenses qualify

When I went to college, a fancy car, a nice apartment, and spring breaks in exotic locations were part of the package for many of my classmates. (My package included public transportation, shoe leather, university housing, and vacations in lovely downtown Baltimore — watching traffic going to the Orioles games was very exciting!) Of course, this was before the days of any qualified tuition plans, let alone Section 529 plans, so the question of what was a qualified expense and what wasn’t never entered the discussion. It was more a question of what your parents could afford and were willing to spend.

Things have changed a little in the intervening years. Now, although all the extra perks are still the norm for many students, parents (and other relatives) who fund Section 529 plans need to be very conscious of what constitutes a qualified higher education expense and what doesn’t. (Trips to Cancun, unless part of your child’s specific university program, and a sports car won’t make the grade.) Table 5-1 lists qualifying higher education expenses.

Distributions from 529 plans that pay for nonqualifying expenses will qualify for income tax on the earnings portion (not on the amount of your contribution into the plan). Your student will also pay an additional 10 percent tax on the income, otherwise known as a penalty, unless she qualifies for an exception (see the section “Exceptions to tax-free distribution rules”).

Table 5-1 Qualified Higher Education Expenses for 529 Plans

Type of Fee	Full-Time Student at	Part-Time Student at
	an Eligible Institution	an Eligible Institution
Tuition	Yes	Yes
Room and board (paid	Yes	If enrolled half time or more,
directly to educational		yes; otherwise, no
institutions)
Room and board (paid	Yes, to extent allowed by	If enrolled half time or more,
directly to other	budget amount set by	yes, to extent allowed by
landlord and grocery	school	budget amount set by school;
store)		otherwise, no
Fees (as required by	Yes	Yes
the institution)
Books, supplies, and	Yes, to extent allowed by	Yes, to extent allowed by
equipment (including	school	budget amount set by budget
computers)		amount set by school
Expenses of a special-	Yes (regulations defining	Yes (regulations defining quali
needs beneficiary	qualifying expenses are	fying expenses are still pending)
necessary for enroll-	still pending)
ment at an eligible
institution

All eligible schools are now required to provide you not only with the price of what you will pay them directly (tuition, fees, and often room and board) but also the total cost of what they expect an academic year to cost. This is called the budget, or the total cost of attendance, and includes tuition, fees, room and board, books, supplies, insurance, transportation, and miscellaneous items. Remember, even though the total budget amount may be higher, only the expenses in Table 5-1 are qualified for payment from a Section 529 plan.

Qualified expense limitations

The amount of qualified expenses you may be able to use Section 529 plan distributions to pay for are limited if you fall into any of these categories:

If your qualifying student receives tax-free educational assistance (outright grants and scholarships), the amount of expenses that would otherwise qualify will be reduced by the amount of the tax-free aid.

If your qualifying student is also the beneficiary of a Coverdell Education Savings Account (see Chapters 8 through 10) and receives distributions from that plan, all qualified expenses need to be divided proportionately between the two plans. You can’t double dip, or take the full amount of qualifying expenses from each plan.

If you want to take the Hope and/or Lifetime Learning Credits on your income tax return, you need to use taxable income to pay for at least a portion of your student’s qualifying expenses. See Chapter 17 for a discussion of what expenses qualify for these credits and how they work.

Exceptions to tax-free distribution rules

Beginning in 2002 and currently scheduled to end after December 31, 2010 (the “sunset provision”), distributions made from Section 529 plans for payment of qualifying educational expenses are free from federal income tax (state income tax rules may differ — check with your state). The federal government has found an effective way to provide incentives for you to send your children to college; however, it has also built in many safeguards to make certain that you don’t abuse its kindness.

When taxable distributions do occur, the federal income tax is paid by the designated beneficiary, not by the contributor(s) to the plan (rules regarding state income tax vary by state). Often, the rules aren’t clear, even to the IRS, or your situation may be ambiguous. Don’t hesitate to seek advice here.

The following are instances where the designated beneficiary may be required to pay a federal income tax on distributions from a Section 529 plan:

Using plan distributions to pay nonqualifying expenses: If the designated beneficiary takes a distribution but doesn’t use it to pay qualified expenses, he or she is basically out of luck. The accrued earnings on that distribution will be taxed at normal income tax rates, plus an additional 10 percent for trying to pull the wool over the government’s eyes. The news here is not all bad, though; if only a part of the distribution is used to pay nonqualified expenses, the entire distribution isn’t tainted. Only the earnings on the portion that didn’t pay qualified expenses will be taxed.

Terminating a plan, because the designated beneficiary chose not to continue his or her education or because some money is still left in the plan after completing that education: When a plan is terminated (rather than rolled over into another plan or beneficiary), the earned income that’s distributed, whether to the designated beneficiary or the plan owner, along with the original contribution amounts is taxable. In addition, it’s subject to the 10 percent additional penalty. Likewise, if the plan contains more cash than the designated beneficiary will use for qualified higher education expenses, the income portion of that excess distribution is taxable, and the 10 percent additional tax applies.

Taking plan distributions from an institutional plan before January 1, 2004: If you set up a plan with a specific college or university or a consortium of colleges and your designated beneficiary begins to take distributions before January 1, 2004, for qualified expenses, he or she will have to pay the income tax on the accrued earnings, but not the additional 10 percent. Unfortunately, the tax-exempt distribution rules for institutionally administered plans don’t come into play until January 1, 2004; fortunately, because institutional plans only came into being in concept in 2002 and in actuality in 2003, not too many people should be affected.

Distributing funds on account of the death of the designated beneficiary: If you need to distribute funds to a beneficiary’s estate or to someone other than the designated beneficiary of the plan, due to the death of that beneficiary, the earned income portion of the distribution is taxable; however, no additional 10 percent tax is assessed.

Making distributions due to the long-term disability or impending death of the designated beneficiary: In much the same way as insurance companies can now prepay life insurance policies to terminally ill patients without any adverse tax consequences, the IRS now allows distributions from Section 529 plans to be made to terminally ill beneficiaries and to beneficiaries with a long-term and indefinite disability. The earned income portion of these distributions is taxable, but no 10 percent additional tax is assessed. You do need to provide the IRS with a doctor’s note to qualify for this exemption.

Using the Hope or Lifetime Learning Credits: To the extent that you use certain qualified educational expenses to qualify for the Hope and Lifetime Learning Credits (see Chapter 16), those expenses will no longer qualify for tax-free treatment, even if you paid for them from your Section 529. The earnings portion will be taxed, with no additional 10 percent tax; again, no double dipping is allowed.

Receiving education benefits that are excludable from gross income: If you’re fortunate enough to receive qualified scholarships, veteran’s assistance, funds from employer tuition-reimbursement plans, or other tax-free benefits (excluding gifts, bequests, or inheritances), the earnings on Section 529 plan distributions are taxable only if the amount of the 529 plan distribution is less than or equal to the amount of other tax-free educational assistance. There is no 10 percent additional tax. For example, if your student’s qualified expenses equal $20,000, he receives a $20,000 tax-free scholarship, and you make a $20,000 distribution to him from his Section 529 plan, he will pay income tax on the earnings portion of the 529 plan distribution, but no penalty, even though none of the distribution is being used to pay qualified educational expenses. From the IRS’s standpoint, it’s enough that it would have been used for that purpose if your student hadn’t received the scholarship.

Contributing to a 529 Plan

Contributing to a 529 plan may seem quite simple — you write the check or get the money automatically withdrawn from your checking account, and those funds get deposited into the 529 plan. That much may be true, but you still need to review the restrictions in this section so that you know who can contribute to 529 plans and how much can be contributed so that you avoid — as much as possible — any complications, such as the tax man.

Figuring out whether you can contribute

Anyone can set up a Section 529 plan (whoever creates an account under Section 529 is considered the plan owner). You don’t need to be a parent, grandparent, or even a doting aunt or uncle. You don’t need to meet any relationship test. You can even set up a plan and name yourself as the designated beneficiary if you’re planning on going back to school.

In fact, the rules regarding who may contribute are so broad that you really need to consider only one major factor before you open a Section 529 plan: Make sure that you have a designated beneficiary (who already must have a Social Security number) in mind and, if he or she’s not a sure thing, one or two beneficiaries in reserve. Section 529 wasn’t devised to allow you to save money tax-deferred for any other purpose (you have your retirement accounts for that). If, at a later date, your named beneficiary turns out to be a less than sterling student or decides to forgo higher education altogether, you may change your designated beneficiary through a tax-free rollover into a new account or just by changing the name of the designated beneficiary on the account (see “Transferring and rolling over plans,” later in this chapter). The new beneficiary, however, must be related to the original one, as described in the section “Making sure your student qualifies,” earlier in this chapter.

Estimating how much you can contribute

In establishing Section 529 of the Internal Revenue Code, Congress and the IRS didn’t set express limits on how big these plans could be. They had a tacit understanding that higher educational expenses couldn’t be accurately gauged and that annual increases bore no relation to the rate of inflation or any other such economic measurement. If they truly wanted to be responsive to the needs of many to be able to sock enough money away, they knew the plans had to be nonrestricting in their contribution limits but not so open-ended that people could stash fortunes away inside these plans.

The IRS set no specific dollar limits on the amount of money you may contribute into an individual plan, either annually or over the life of the plan. Instead, it limited the amount you could contribute to the amount of qualified expenses your student is going to need for higher education. This is where you’ll have to do some guessing. Although there is no dollar limit, if you contribute more than your student will eventually spend on qualified educational expenses, the deferred earnings on any amounts that you contribute over and above will be taxed when you distribute them. The earnings are also subject to an additional 10 percent tax.

Before you consult your crystal ball regarding how much you think you should contribute, you need to take into consideration Gift and Generation-Skipping Transfer Tax issues and individual state contribution limits.

Gift and Generation-Skipping Transfer Tax considerations

Section 529 plans were devised to allow all people, regardless of their annual income, to save very large sums for higher education expenses. Because there are no annual contribution limits, you may be tempted to sell the family farm and put all that cash into one or more plans. If this sounds reasonable to you, you need to remember that contributions that you make into a plan for any person (other than yourself or your U.S. resident spouse) are subject to the gift and/or Generation-Skipping Transfer Tax (GSTT) rules (see Chapter 3).

The gift tax regulations include one unique provision, applicable only to Section 529 plans. You may contribute up to five years’ worth of annual exclusion gifts ($55,000 in 2003, or 5 x $11,000) in one year. If you’re married, your spouse can do the same, enabling you to push $110,000 into a plan for one designated beneficiary in a single year (for more info on gift splitting, see Chapter 3). Should you choose this option, you must file gift tax returns for each one of the five years, claiming your annual exclusion gifts. Furthermore, any additional gifts that you make in the five-year period are then subject to the gift tax or GSTT.

Gift and Generation-Skipping Transfer Tax returns (Form 709) aren’t for the weak of heart. Find a professional with expertise in this area (many pros don’t have it). Mistakes here are costly, and if they’re discovered after the death of the donor (that’s you), they’re impossible to fix. Don’t take that chance!

Contribution limits imposed by the states

The federal government doesn’t impose any specific dollar limitation on the maximum contribution into Section 529 accounts for a specific beneficiary. But the code section is intentionally vague. And most plans are administered by the individual states: They have far more definite ideas as to the actual dollar amounts necessary to see your children through four years of college.

State-imposed contribution limits vary by state, and the state law that governs your account will be the state in whose plan(s) you are investing, not the state in which you live. Thus, you can invest money in a high-limit state, even if you live in a low-limit state. Also, be aware that states have the ability to change their limits (and often do), increasing them as tuition costs climb.

You really need to shop for plans. Although every state has plans either established or under development, some states limit participation in their plans to state residents, and some states offer a variety of different plans. Some states give you a current income tax deduction or tax credit for contributions into their plan, and some, but not all, follow the federal rules and treat the earned income portion of withdrawals as tax-exempt. The appendix in the back of this book lists state plans at the time of publication. In addition, you can access every plan through its sponsoring state’s Web site or through college saving Web sites such as www.savingforcollege.com .

Don’t rely totally on Web sites for information regarding a specific plan. If you have any questions or see conflicting information, contact that plan manager, who will have the latest info on the plan in question.

Contribution limits aren’t per account, but per designated beneficiary. Your designated beneficiary may have more than one Section 529 plan set aside for his or her use; however, the total aggregate account size in all plans in a particular state can’t exceed the limit for the state in which the plan resides. States don’t share info, though, so if you begin to bump against the ceiling set by one state, you can open a plan in another state. Just make sure that all the money in all of your plans is used to pay qualifying expenses for your student; the income portion of any excess will be taxed and penalized.

Picking Your Plan

I will never forget my high school American history class, where the only lessons I carried away with me were multicausation and that the story of the United States was the ongoing push/pull between the federalists (those who wanted a strong central government) and the states’ rights supporters.

Section 529 plans clearly illustrate that the discussion is far from over. The code section is a federal one, the application is almost entirely on the local level, and every state’s rules are slightly different. So this is where things get interesting. You know that, in theory, this type of plan makes sense for you and your family, but you’re not quite sure what type of plan you should invest in and where.

Discovering the different plans

Not all Section 529 plans are alike. They all have different contribution limits. Some plans allow only residents of their states to participate, while others open their plans up to everyone.

There’s an even larger difference in plan types, however. Original 529 plans were all done on the basis of prepaying tuition; the more common savings plan (which is what most people think of when they think of 529 plans) is a later addition, designed for greater flexibility but perhaps more risk.

Prepaid tuition plans administered by the states

Prepaid tuition plans, as the name suggests, are just that: the purchase of tuition to a particular school or group of schools ahead of when your student will attend. The state (in 2003, about one-third of states had a prepaid tuition option) or a particular school may administer them (see the next section, “Prepaid tuition plans administered by educational institutions”).

In general, prepaid tuition plans, or contracts, allow you to purchase future tuition at current costs. For example, assume that your son will be attending a local state university in 2006, where current tuition is now $4,000 per year, but which you expect will cost $5,000 per year by the time he attends. You have $16,000 available (you just sold one house and didn’t plow all the proceeds back into a new one, perhaps), and you invest it in a prepaid tuition plan while tuition is still just $4,000 per year. If you purchase the equivalent of four years of tuition at its current cost (4 years x $4,000 = $16,000), when your son is ready to attend school, the proceeds from the plan will pay all of his tuition costs (4 years x $5,000 = $20,000). By purchasing $16,000 worth of tuition now, you expect to receive $20,000 worth of tuition down the road.

If, on the other hand, he chooses to attend a college or university whose tuition costs at the time you invested in the plan were greater than $4,000, the plan will pay a percentage of the higher tuition equal to your original contribution’s value against the other school’s higher cost. If he attends a school that cost $10,000 at the time the plan was purchased (but that now costs $16,000 per year), the prepaid tuition plan would pay 40 percent of the cost of his tuition at the time he entered the higher-priced school, or $6,400 per year. In this scenario, your initial $16,000 investment in your son’s education reaps you $25,600 worth of tuition when he actually attends.

With a prepaid tuition plan, your money is guaranteed to buy a certain amount of tuition. You don’t need to buy all the tuition at one time — you can buy any part of one or more years — but whatever amount of money you put into this type of account is guaranteed to buy as much tuition in the future as it would on the day that you put it in.

Just because you think that you’re buying a sure tuition payment at the end of the rainbow, don’t bank on it. Many states don’t absolutely guarantee full tuition payments at the time your student attends, even if that’s what you thought you purchased. And because the entire rationale of prepaying tuition is based on the assumption that the amount of income earned on your investment will at least equal the increase in college tuition, many states have found their prepaid tuition plans to be a losing proposition. If the value of your investment isn’t keeping pace with tuition inflation, most states do provide a state remedy so that you probably won’t need to find additional cash to pay for the shortfall between the actual value of your investment at the time you need to cash it in to pay for tuition and the real cost of tuition. Every plan is different, and plans (and state legislatures) can change funding provisions as the need arises. Stay current, and don’t invest in any plan until you have read, and understood, the most recent plan provisions.

Whether or not your state plan carries a guarantee, Section 529 prepaid tuition plans are trying to ensure a certain payback at a certain time. Because of this, these plans carry several restrictions that Section 529 savings plans don’t. Check these restrictions carefully. Among the limitations are the following:

Most plans carry restrictions as to who may participate. Usually either the owner of the account or the designated beneficiary is required to be a state resident at least at the time the account is established.

Most plans carry restrictions as to what colleges, universities, and community colleges are covered by the plan. Generally, the state schools are covered; tuition coverage at private colleges and universities within the state is spotty, and tuitions out of state, while not entirely out of the question, can be problematic. You need to check what schools are covered before signing up for a particular plan.

Many prepaid tuition plans cover only tuition costs. Room, board, and other fees have to be paid at the time your student is attending, from current income or other savings, like a 529 savings plan.

Most prepaid tuition plans have a limited enrollment/contribution period each year. If you plan on or are currently investing in a plan, don’t miss your window of opportunity.

The contribution limits for prepaid tuition plans are significantly lower than for Section 529 savings plans; if you’re attempting to use a 529 plan to transfer a lot of money to a designated beneficiary and to defer or avoid income tax on the earnings, the prepaid tuition option may not be the best vehicle for you.

If you need to cancel the plan for any reason, be aware that normally fees are charged for terminating the account. In addition, many plans limit the amount that you receive on cancellation to either your contribution amount (less cancellation fees) or your original contribution plus some small percentage of income.

Distributions on behalf of the designated beneficiary currently are counted as being totally available to pay tuition, and thus may decrease financial aid eligibility (see Chapter 17).

Prepaid tuition plans administered by educational institutions

If you know for certain and beyond any reasonable doubt that your child or grandchild is going to attend a certain school in the future (your alma mater, perhaps, because you’ve already donated the fieldhouse and the science lab?), an institutional prepaid tuition plan may be just the ticket for you.

Since 2002, educational institutions have been allowed to offer their own prepaid tuition plans. These plans are essentially the same as state-run prepaid tuition Section 529 plans, except that individual institutions (or consortiums of colleges and universities) administer them and the contributions that you make are restricted to use at that particular college or university or that particular group of schools. Make sure that your institution has a plan already in place; not many schools have signed on at the time of this writing.

The rules governing these plans are the same as for the state-run plans. Contribution limits vary from school to school, depending on current tuition costs.

Like all other 529 plans, those administered by an educational institution are transferable; if your designated beneficiary decides to attend a different school, you can transfer your account to another plan administrator (see the section “Transferring and rolling over plans,” later in this chapter). In addition, if your designated beneficiary chooses not to attend school at all or receives some sort of free ride, you can make a tax-free rollover and name a new designated beneficiary, so long as the new beneficiary falls under the allowed relationship rules (see the section “Making sure your student qualifies,” earlier in this chapter).

Savings plans

Savings plans are probably what comes to mind when you think of 529 plans. The Section 529 savings plan option broke open the world of college savings, offering truly huge tax advantages to the wealthy and the not so wealthy.

A Section 529 savings plan is, in many regards, an investment account. Although states may establish the rules, most of these state-sponsored plans are actually administered by mutual fund companies, or fund managers. Having a fund manager in charge of your money has many benefits, including the fact that these companies hire investment professionals, who you hope will wring a better return out of your money than the state will.

That’s the theory, anyway, and for several years in the 1990s, when the stock market soared, it was the practice, as well. These funds far outperformed anything the states could do (the states tend to be extremely limited in the investments that they can make with your contributions into a prepaid tuition plan). The fact that you may have had to pay a broker’s sales commission to enter the fund and that you were also paying annual management fees to the fund manager made little difference. Your investment was increasing in value. Though your actual contributions into the plan may have been modest in size, visions of college and graduate school began dancing in your head.

Stock markets don’t always soar, however, and investment markets that are staggering under the weight of years of unsound economics, burgeoning budget deficits, rampant unemployment, and questionable accounting practices tend to affect all mutual funds, including Section 529 funds, negatively. Many investors have watched the value of their savings plans shrink well below their initial contribution amounts. And now, adding insult to injury, the fund managers, who make their money even when the markets are doing poorly, haven’t chosen to waive the fees they charge to manage these accounts. Imagine!

Still, if you envision your son or daughter giving the Latin valedictory address at Harvard at some future date, saving in a prepaid tuition plan isn’t going to fill the bill for you. Section 529 savings plans offer several advantages over their prepaid tuition relatives.

Maximum allowable account size is usually far greater, between $200,000 and $300,000 per designated beneficiary (depending on the state in which you are investing and adjusted periodically as tuitions and other expenses rise).

The value of the plan is counted as an asset of the owner, not the student, when applying for federal financial aid. When applying for financial aid, if the plan owner isn’t either the parent or the child, the amount of money in the plan isn’t included at all in the federal financial aid formula; it may, however, be counted in other formulas the colleges use to determine additional need-based financial aid awards.

Distributions from Section 529 savings plans can be used for all qualified higher educational expenses, not just tuition.

When planning how much to contribute to your Section 529 plan, you don’t need to project costs only for undergraduate school; these plans can be used to pay for graduate schools, as well.

If your savings haven’t produced any earnings at all (your plan is worth less than the amount you put into it when you begin to take distributions), you may claim a loss on your income tax return in the year in which you finally fully distribute the plan. When the amount you have been able to distribute over the years is less than the total of your contributions (your basis), you may deduct the difference between your cost and the amount distributed as a miscellaneous itemized deduction on Schedule A of your Form 1040. This provision adds insult to injury: Not only has your investment lost money, but your deduction will be reduced by 2 percent of your adjusted gross income.

Guaranteed savings plans

Although all Section 529 plans are created equal under the terms of Section 529 of the Internal Revenue Code, clearly the states don’t agree with that, severely limiting the size of traditional prepaid tuition plans in comparison to savings plans. Also, the U.S. Department of Education hasn’t figured out that it should treat plans the same. Instead it gives preferential treatment to savings plans while determining that distributions from prepaid tuition plans are a financial resource that reduces need on a dollar-for-dollar basis, thereby limiting financial aid packages and the awards of outright, need-based grants.

In an effort to address these disparities, a few states have started a movement to meld the two types of plans into a hybrid: the guaranteed savings plan. Guaranteed savings plans follow all the rules and requirements of Section 529 of the Internal Revenue Code and qualify for the same preferred tax treatment as prepaid tuition plans and savings plans.

Each state that offers these plans at the time of this writing (Colorado, Ohio, Pennsylvania, Tennessee, and Washington) has a slightly different take on the same theme: a guaranteed return on your investment, based either on current tuition rates in that state or a stated interest rate, recalculated each year.

So far, this strategy appears to be working. For federal financial aid purposes, plan assets are being counted as the account owner’s assets (not as the student’s), and distributions from plans to pay qualified higher educational costs aren’t considered a financial resource of the student.

The guaranteed savings plan is a sane response to burgeoning college costs, assuring low risk and reasonable (although not spectacular) growth of your savings while not tying you to the more limited contribution amounts of prepaid tuition plans.

Contribution limits in these plans are generally the same as for savings plans administered by those states (except for Washington State, whose plan appears to limit contribution amounts to four-year tuition at an in-state public university — much more in keeping with a prepaid tuition plan limit).

Weighing the 529 plan features

The only thing that is certain about any of these plans is that everything that has come before is subject to change. New plans are being developed, contribution limits are always on the move, old restrictions are removed, and new ones are added. If ever there were a moving target, Section 529 plans would qualify. Still, you should be looking for certain things and trying to get answers to certain questions before putting any money into any fund.

Checking how your state income tax is affected

Section 529 plan contributions often are income-tax deductible, either in whole or in part, on your state income tax return. Often that tax deduction is limited to state residents who participate in their home state plans, but some states give a deduction for a contribution into any plan. You need to check.

You also know that distributions to the designated beneficiary of a plan, to the extent it is used for qualifying higher education expenses, are tax-exempt at the federal level. Many states follow the federal rules and offer tax exemption to the earnings on distributions from their own in-state plans. Other states exempt the earnings from any plan. Finally, some states aren’t yet on the bandwagon, taxing the earnings from any plan, in-state or out.

You also should be aware that some states (those who don’t follow the federal rules) may tax the deferred income earned in accounts when you make a federally tax-free rollover from one state’s plan to another’s. If you invest in an in-state plan and receive a deduction on your state income tax return(s) for your contributions, and then roll your account over to an out-of-state plan, you may also have to add back, or recapture, your prior deductions and pay income tax on them. If the change of plan is advantageous to you otherwise, you may just have to pay the tax and move on.

Many states lack an income tax altogether. If you live in one of these states, feel free to invest in any state’s plan, because your own state doesn’t provide any income tax benefit, either on contributions or distributions.

However, some states have a dividends and interest tax that taxes only — you guessed it — dividends and interest. Because the earnings on Section 529 plans consist of primarily dividends and interest, if you make a nonqualifying distribution, the earnings may be liable for this particular tax. Be familiar with the tax law governing your state and the state where your plan is located.

Transferring and rolling over plans

In the good old days (pre-2002), transferring between plans held for the same beneficiary just couldn’t be done. But beginning in 2002, along with the new, tax-free distribution rules, you now can transfer amounts between 529 plans held for the same beneficiary, although you may not make a tax-free transfer more than once in every 12-month period for a single beneficiary.

Say that you have a 529 savings plan for your daughter. The plan hasn’t done as well as you would like, and your daughter is going to a state university in a few years. You decide to transfer your savings plan into a Section 529 prepaid tuition plan in your state. You can buy four years’ worth of tuition with the amount currently in your savings plan. Because you’ve kept the same beneficiary on the new plan as was on the old, the transfer is tax-free. Should your daughter decide that she wants to attend college at a neighboring state school, you can transfer your 529 prepaid tuition plan for your daughter to the new state, but you must wait for 12 months before doing so.

Tax-free transfers may be made from any type of Section 529 plan to any other type, between states (so long as residency requirements are respected), and even from Coverdell savings accounts to Section 529 plans.

You may also transfer or roll over an account tax-free to a new beneficiary at any time, if you meet the following requirements:

You must complete the account transfer or rollover to a new beneficiary within 60 days from the date the money actually leaves the first account (the original distribution date).

The new beneficiary must be a member of the same family as the original beneficiary, within the permitted relationships.

Finally, even if you don’t roll over an account to a new account, you’re permitted to change the designated beneficiary on any account at any time without any tax consequence if the new beneficiary is a member of the same family as the original beneficiary.

Opening accounts with funds from an UGMA/UTMA account

From the perspective of a child’s well-being, UGMA (Uniform Gift to Minor Act)/UTMA (Uniform Transfer to Minor Act) accounts may be the worst idea since Al Capone decided not to pay his taxes (see Chapter 12). Many of you, though, when faced with the desire to start gifting away substantial amounts of wealth (especially in the rampant stock market of the 1990s), set up these accounts for your children and grandchildren. At the time, when they were babies, putting securities into these custodial accounts seemed like a great idea. The kids couldn’t touch the money (at least not without the permission of the custodian), and it would be there, waiting for them, when they reached college age. What a deal — providing college money for the kids and shrinking your personal estate at the same time.

Now, though, those babies aren’t babies anymore; they’re getting close to those magic ages when all that money becomes theirs, and they’re still incredibly young. For years, they may not know about these custodial accounts, but when they reach age 18 or age 21, they’ll definitely find out about them. They’ll also discover that everything in there is theirs, to use wisely or to fritter. Unfortunately, your child may be the type to fritter.

Surprise! If you want to add at least a layer of deterrent to your child’s ability to squander all, or a portion, of what you’ve saved in an UGMA or UTMA account, you can transfer the money in an UGMA or UTMA account into a Section 529 plan if you are the UGMA/UTMA custodian. A few different restrictions will be in place, though:

The funds you contribute aren’t really yours — they’re funds currently being held in custody for a minor child. Accordingly, although you are the plan owner until the child turns 18, at 18, the plan owner becomes the child. In other words, moving this money into a 529 plan doesn’t allow you to regain control over these savings

You may not choose any designated beneficiary other than the child whose UGMA/UTMA account originally funded the plan, and once the designation is in place, you may not change it.

When the plan reverts to the child’s ownership at age 18, he or she can take whatever distributions he or she wants, regardless of whether the money will be used for educational expenses. If the money is not used for qualified expenses, however, income tax on the earnings, plus the 10 percent penalty, will be assessed.

Using UGMA/UTMA accounts to fund 529 plans makes the money more expensive for a child to access to buy that sports car or take that trip (because of the addition of the 10 percent penalty on top of the income tax owed), but it doesn’t make it impossible. Hopefully, the additional cost will make the new account owner think twice before spending the money unwisely.

Opening multiple accounts

As a plan owner, you may open as many Section 529 plans as you want, in as many locations as you can and that make sense for you, provided you have enough designated beneficiaries to go around. You may not have more than one designated beneficiary per account; however, a designated beneficiary may have more than one account set up for him or her. If you’re purchasing prepaid tuition but your prepaid tuition plan covers only tuition, also investing in a savings plan often makes sense. When your student finally begins his or her college career, you’ll have money in the savings account to pay all the qualified expenses the prepaid tuition plan won’t.

If you come from an incredibly generous family, you may want to be certain that the aggregate amount in all the plans for one designated beneficiary does not exceed the amount of qualified expenses that beneficiary is likely to incur. Excess contributions trigger income tax and a penalty on the income portion of the balance not used for higher education expenses. However, if you do find yourself in this situation, you may want to consider changing the designated beneficiary on one or more accounts. You can even transfer it to yourself and retrain yourself in a new field or pursue a long-held interest.

Assessing the risk

Very few things in life are sure, and most 529 plans belong in the “not sure” category. Anytime you put money into securities other than savings or money market accounts, you put your nest egg at risk. Investments can fall in value as easily as they can rise, as many a dismayed investor has found.

The riskiest of all Section 529 plans are the savings plans, although not all savings plans carry the same level of risk. These plans are tied most closely to the stock and bond markets and will enjoy the same bumpy ride. The gains can be spectacular (in a strong market and with a good plan manager); the losses can be devastating. Seeing the value of your savings decrease is never easy. Watching your child’s education seeping away is especially difficult.

Both guaranteed savings plans and prepaid tuition plans are much safer than savings plans, as they’re usually tied to specific investments that are less volatile. Many prepaid tuition plans may invest only in state obligations (read municipal bonds), which have a fixed rate of return over their lifetime, although bond prices can fluctuate. Although your gains will not be huge, provided that you hold on to your tuition certificates or your guaranteed savings account and redeem these accounts only to pay qualified expenses, you should do all right.

Still, tuition costs often rise higher than the return on the modest investments these accounts are allowed to make. If the earnings in an account don’t keep pace with tuition hikes, the state administering the plan may discount the amount of tuition you think you’ve purchased. You may think that you’ve funded four years of tuition, but you actually end up with only three.

Most states without a guarantee have provisions in place to make up any deficiencies between the earnings in their plan and the actual costs. Some states may devote lottery monies, while others may take a percentage of unclaimed property and devote this to the shortfall. Very few states without a guaranteed return on prepaid tuition plans or guaranteed savings plans lack any contingency plan at all. Carefully investigate the plan you’re thinking of investing in for these safeguards.

Finally, some states absolutely guarantee that the tuition you think you’re prepaying is actually going to be paid, in full, to the extent that you’ve purchased it. These gold-plated plans often have residency requirements for the plan owner, the plan beneficiary, or both. Check carefully.

Now, because states actually administer so many Section 529 plans, you may be wondering whether the states can liberate money you contribute into any plan and divert it to another function. The answer is unequivocally no! Money that you put into any Section 529 plan is segregated from all the other money that states collect or hold. It is segregated from all tax revenues, and the state (or plan manager) must account for it at all times. Siphoning money away from a registered account (because that’s what these accounts are) is theft, even if it’s done by the state.