Is a 529 Plan a smart way to save for college?

1/7/13

Dear Uncle Sam,

    My grandson is only 5 years old, and I would like to help brighten his future. I have heard people mention a 529 Plan, but I don't know much about it. Is a 529 Plan a smart way to contribute to his future college costs? Are there any risks involved? Do I report my contributions when I file my tax return?

Thank you,
Mary in Edison


Dear Grandmary,

       If there’s one thing we could all agree on, it may be that the cost of attending college has become nearly unmanageable for many students and their families. While most figures adjust for inflation over the years, the cost of college is increasing at a rate that is highly disproportionate to the average growth in salaries and the cost of consumer goods. There’s been mounting outrage in recent years, as graduates enter the workforce with great debts and not-so-great job prospects. Many generic office jobs now require Bachelor’s degrees, and employers can have their pick of the litter for a position with a modest entry-level salary. Planning and saving is not an easy accomplishment for every family of a future college student, but those who can, should. A “529 Plan” can be a wise method for doing so.
      Created by Congress in 1996, and placed within section 529 of my beloved Internal Revenue Code, the Qualified Tuition Program (QTP) is an investment product that provides for tax-free growth and nontaxable treatment of qualified distributions. Qualified distributions are used to pay for tuition and related fees at accredited colleges and other post-secondary institutions. The plans themselves are operated by states and educational institutions, and investors can generally pick the one that is most appealing. Each established plan has only one designated beneficiary, but there are no limits to how many plans one person can set-up. Plans are most commonly established for children and grandchildren, but can also be done so for non-relatives and even for one’s own educational purposes.
       There are 2 types of 529/ QTP plans- prepaid tuition plans and savings plans. US states can and do offer both types, but educational institutions that are a part of the Independent 529 Plan are only permitted to offer prepaid plans for the future benefit of their collective students. The primary appeal of a 529 plan is tax savings on growth (for the savings plan) and a tuition “break” (for the prepaid version). Although growth on investment is not a guarantee, a satisfactory rate of return can substantially save on taxes, especially if higher-earning parents are claiming the child in a year of distribution/ college attendance. Taxpayers may be ineligible for education tax credits for different reasons (income, filing status), so a 529 Plan can be an alternative tax perk.
       529 Plans are arguably most appealing to grandparents who wish to pass down money wisely, and prior to death. As the Estate Tax’s threshold threatens to lower each year, planning ahead cannot be overvalued. There is no guarantee that the exemption amount will be upwards of $5-$6 million here on out. Depending on your situation, a “5 year election” may be an option for making a larger gift tax-free contribution in a single year.
       As far as risks? The 529 savings plan is an investment product. Investing involves risk, and past performance is not indicative of future results. Consult with a trusted financial advisor before investing in a 529 plan, and always be sure to read the prospectus yourself. Some state plans may require attendance at specific educational institutions, or place other parameters on the investment. Similarly, prepaid plans may place a cap on their future value. Do not assume that every prepaid plan is like the forever stamp of tuition. Assuming inflation is nevertheless a safer bet than portfolio performance, some may opt for the prepaid 529. Despite the obvious appeal to risk-adverse “investors”, there is the drawback of locking your designated beneficiary into a limited consortium of schools, or even a state that may be unappealing or inconvenient to their career goals and future situation. The earlier in the child’s life the prepaid tuition is purchased, the better the savings is likely to be and the more uncertain the child’s future may be. That is another form of risk.
       As far as your federal tax return is concerned, you do not report 529 contributions. However, contributions may still be subject to gift tax if limits are exceeded. Some states offer a tax benefit for 529 plan contributions, but New Jersey is not currently one of them. At that, many states with a tax benefit do not permit their residents to deduct for contributions to other states’ plan. Consult a tax professional for a personalized response. The 529 plan is a multifaceted product that requires proactive consideration. If there's one thing Uncle Sam always backs, it's good old-fashioned homework!

Thank you for being an informed taxpayer,

Your Uncle Sam
For the purpose of this web page, Uncle Sam is the pseudonym of Christina Sharkey, Enrolled Agent.
CIRCULAR 230 DISCLOSURE : IRS Regulations require Sharkey Tax LLC to notify you that this communication is not intended to be used, and cannot be used, by you as the taxpayer, for the purpose of avoiding penalties that the IRS might impose on you.