529 Plans: A Powerful Estate Planning Tool


529 Plans: A Powerful Estate Planning Tool


For several years now, so-called '529" college savings plans have been an appealing way for
grandparents or others to fund a child's college education. After a change in the tax law last
year, however, these savings plans have become downright irresistible.

Assets in 529 plans are soaring, with nearly $200 billion expected to pour into them by 2007,
up from an estimated $25 billion in 2002. The plans are particularly appropriate for
grandparents with taxable estates-over $1 million for an individual or $2 million for a
married couple-who wish to help grandchildren with college and reduce their taxable estates
at the same time.


Having Your Cake and Eating It, Too

These plans, named for Section 529 of the Internal Revenue Code, are similar to Roth IRAs
in that a taxpayer reaps no federal tax deduction for making the investment but, beginning
in 2002, the beneficiary of the plan (the child) pays no tax on withdrawals from the account
as long as the funds are used for his or her qualified educational costs (i.e., room and board,
tuition, books, supplies, etc.).

But perhaps best of all, while contributions to 529 plans are removed from the account
owner's estate, the owner doesn't lose control over the funds. With very limited exceptions,
the account's beneficiary has no rights to the funds. The account owner decides when
withdrawals are taken and for what purpose. Most plans even allow the account owner to
take back the gift if necessary (although a 10 percent penalty will apply and the owner will
have to pay taxes on any earnings upon withdrawal).

Anyone can create a 529 account: a parent can create one for a child, or a grandparent can
create one for a grandchild (or for anyone else). Contributions to these accounts are limited
to $11,000 per recipient annually without triggering a gift tax. However, the law does permit
advance funding. A family member can make a maximum contribution of $55,000 in one
year and still not exceed the gift tax limit, as long as the owner doesn't make any additional
gifts to the beneficiary during that five-year period. However, if the donor dies before the
five-year period is over, a portion of the gift will be included in the owner's taxable estate.
The total amounts that can be placed in 529 accounts are substantial ($250,000 or more per
beneficiary under some state plans). Generally speaking, there are no income limitations or
age restrictions.

In addition, account beneficiaries can be changed without income-tax consequences if the
new beneficiary is a family member of the original beneficiary, including a cousin. However,
there will be gift-tax consequences if the new beneficiary is in a younger generation than the
original one.

What if the child doesn't go to college? The account owner pays a 10 percent penalty on
earnings, in addition to the tax on those earnings. However, this penalty is not assessed if
the account is terminated because the beneficiary is disabled or if unneeded funds are
withdrawn because the beneficiary receives a scholarship.


Choosing the Right Plan

There are two types of 529 programs: a pre-paid program and a savings program. The pre-
paid program allows states to offer pre-paid tuition contracts to cover tuition for higher
education. This program has a limited choice of schools for which the tuition contracts are
applicable. The more popular savings program, on the other hand, may be used for any
accredited post-secondary school in the United States.
The biggest problem with setting up a 529 plan is choosing the right one. All plans are
created under a particular state's law, but in general anyone can participate in any state's
plan. For example, you could live in California and contribute to a Maine plan for your
grandchild who lives in Virginia and who ends up going to college in New Mexico. Most
state plans even allow you to set up a 529 savings account for yourself.
But the quality of the state plans, and their rules and regulations, vary dramatically. The
savings programs are created by the states in conjunction with financial services companies
that administer accounts and invest the plan owner's money until it is withdrawn by the
beneficiary. Each state has its own rules and each financial services company has its own
charges. Depending on the state and the company, the owner has more or less flexibility and
control over the investments. As just one example, while most states allow the account
owner to change beneficiaries, some don't.
The best place to compare 529 college savings plans is at the Web site
www.savingforcollege.com . The site features a 529
Evaluator and gives each plan a rating. For a snapshot of all the plans, see Business Week's
Guide to College-Savings Plans at

USA Today recently rated 43 such plans, giving the College Savings Plan of Nebraska top
honors. The newspaper also praised Virginia's CollegeAmerica, the Michigan Education
Savings Program, the Tennessee Baccalaureate Education Savings Trust, and the Minnesota
College Savings Plan. All of the top-rated plans featured below-average fees and expenses,
which can be critical when the stock market is stagnant or declining.

Making Your 529 Account Grow
Account owners can't directly manage the savings plans themselves. Instead, investment
houses manage them, usually in the form of mutual funds. The number of investment
options varies from state to state, ranging from only a few funds to almost 30.
Many plans have preset investment strategies depending on the beneficiaries' age, investing
more in stock when the future college student is young and more in bonds and other fixed
investments as the beneficiary gets closer to college age. This can be a problem if the donor
puts in a large amount of money at once while the child is young and while the market is
high, and then it drops suddenly. Gradual funding over time--known as 'dollar cost
averaging'--can avoid this risk. There also are fixed-income "stable value" funds and
guaranteed investment contracts (GICs) that guarantee principal and pay interest. Nearly all
the plans run by TIAA-CREF offer GICs, including California's, Michigan's, and New
York's.
Once you've chosen your asset allocation strategy, you can't change it for 12 months. You
also must wait a year to transfer to another plan if you're not happy with the one you're in.



Don't Forget the Impact on Financial Aid and Medicaid

The one main drawback to 529 plans is that their existence can prevent a student from
qualifying for financial aid. According to the U.S. Department of Education, if a parent is
the account owner, *what about a grandparent? only 5.6 percent or less of the value of the
account is counted as contributable towards a child's college costs. However, once the child
starts making withdrawals to pay for college expenses, financial aid for the following year
can be affected more significantly. Financial aid officials count half of all 529 account
earnings that are withdrawn to pay college expenses.

Grandparents who set up plans should also be aware that if the grandparent remains the
owner of the plan and later applies for Medicaid coverage of nursing home care, Medicaid
officials will count the funds in the plan among the grandparent's available assets. This
could either render the grandparent ineligible for Medicaid or delay eligibility. One solution
is to name someone else-such as the parent of the child beneficiary-as the owner/controller
of the account.