This guide to 529 savings plans was specially prepared for Grandparents.com readers by James S. Kaplan, Esq, head of the Herzfeld & Rubin Tax and Estates Department, and associate Amy Altman, for Herzfeld & Rubin on April 6, 2011. It is provided here as a resource for our readers. The opinions and analysis are Mr. Kaplan's and Ms. Altman's alone.
Grandparents who wish to put aside funds for a grandchild's college tuition may benefit by investing in a 529 plan. Funds placed into such a plan grow free from federal and state income taxes, and many states provide an additional state income tax deduction for resident investors.
A 529 plan, or a "qualified tuition program," is a tax-advantaged investment program maintained by a state or an eligible education institution for the higher-education expenses of a designated beneficiary. The plan is named after section 529 of the Internal Revenue Code, which is designed to encourage savings for higher education. Everyone is eligible to take advantage of a 529 plan — there are no income limitations or age restrictions.
Although contributions to a 529 plan are not tax-deductible, earnings in the account accumulate tax-free, and distributions of principal and earnings are tax-free for the beneficiary as long as they are used for qualified higher-education expenses. Further, Section 529 plans are given favorable estate, gift, and generation-skipping tax treatment.
There are two types of 529 plans — prepaid plans and savings plans. Most states provide the savings option, the performance of which is completely based on market performance of the investment vehicles, usually mutual funds. A minority of states — 11 — provide the option of prepaid plans, which permit the donor to purchase tuition credits at today's rates for use in the future. This plan relies upon tuition inflation to judge its performance.
While most states have their own plans which allow out-of-state contributions, generally speaking, there are more advantages associated with investing in the 529 plan in your state of residence. These advantages may include a state tax advantage, matching grant and scholarship opportunities, protection from creditors, and exemption from state financial aid calculations. For example, New York taxpayers who open a 529 plan in New York state can also deduct up to $5,000 of their contributions (or $10,000 for a married couple filing jointly) on their state income tax forms each year. Withdrawals are also exempt from New York state income tax when used for qualified higher-education expenses. Others states that allow state income-tax deductions include Alabama, Arizona, Arkansas, Colorado, Connecticut, Georgia, Illinois, Massachusetts, Maryland, Michigan, Mississippi, Pennsylvania, and Rhode Island. The amount that can be taken as a state income-tax deduction varies from state to state.
Another added advantage of 529 plans is control. The donor remains in control of the account and, in most cases, the beneficiary has no right to access the funds. The donor can even change the beneficiary of the 529 plan at any time. However, the account's continuing investment strategy is maintained by the plan, which is professionally managed by the state or an investment company. The fees are typically low and vary from state to state.
Donors may change their mind and decide to reclaim the assets of a 529 plan for their own use. In such a case, however, the assets will be subject to income tax and a 10 percent penalty on any gains, although these reclaimed assets will not be counted as part of the donor's gross estate for estate-tax purposes.
Since contributions to a 529 plan are considered gifts under federal gift-tax regulations, contributions in excess of $13,000 per year if filing single ($65,000 over five years) — or $26,000 per year if filing jointly ($130,000 over five years) — count against the lifetime gift-tax exemption. However, since the gift tax exemption was increased to $5 million as of January 1, 2011, the risk of having to pay gift tax is low.
There are real benefits of maintaining a 529 account for one or more grandchildren — watching the funds grow free from federal and state tax; tax-free withdrawals of funds as long as they are used for qualified higher education expenses; and donor control over the funds and beneficiary changes. If you have not yet looked into starting a plan of your own, now may be the time.
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