taken from the November 2002 AAUP AZ Advocate

529 Plans: College Saving for Kids and Grandkids

by Ray Martin, CFP

Financial Directions, LLC

Section 529 of the Internal Revenue Code enables states to sponsor programs, with tax advantages, designed to help families save for future higher education expenses. These plans have become more prominent and more States are participating largely because of the advent of the Economic Growth and Tax Relief Reconciliation Act of 2001, which significantly strengthened the tax advantages that a 529 savings plan may provide.

Income Tax Advantages

Contributions to a 529 plan go in on an after-tax basis, but the income and growth derived from them may be withdrawn tax-free if used for qualified higher education expenses! This combination of tax deferred accumulation and tax-free withdrawal is key to the plan’s attractiveness.

High Contribution Limits

Another key to the plan’s attractiveness is that the contribution limits are extremely high with no family income limitations. This new tax code was a serious effort to encourage families to create adequate funds available for higher education. Some of the less populous states, with few state colleges, actually set very high limits that represent the average cost of four years at the private colleges throughout the nation. A typical high total contribution limit per plan is $250,000. This is not your father’s education IRA!

Estate Planning Advantages

A third key to the plan’s attractiveness is that it allows for up to five years of annual tax-free gifting to be aggregated and deposited to the plan in one tax year. This allows the family to jump-start the plan. This can be done for each established 529 account, as only one beneficiary can be designated per account. These maximum tax-free gifts to the plan must however, be prorated on the family tax returns over a five year period, going forward.

For grantors with potentially large taxable estates, contributions to a 529 savings plan are not considered to be part of the taxable estate and can potentially reduce the estate tax bill. Unlike the case with some other estate planning vehicles, the grantor can retain control over the disbursement of funds without estate valuation repercussions.

Control

Prior to now, the most common vehicle for college funding has been through the State’s Gift/Trust to Minors Act. Considerable funding may continue to go that way; however, once the gift is made to a minor it belongs to the minor even though it is held in custody by an adult for the sole benefit of that minor.

With a 529 plan, you don’t have to worry. The adult owner controls the growth and disbursement of the funds. The owner can change the beneficiary of the fund at any time. The owner does not have to be the grantor. For example, a grandparent can gift (from their estate) to their adult child as the owner of the plan account with their grandchild as the named beneficiary. The owner controls the account. If the first designated grandchild does not opt for higher education, the owner can designate a new beneficiary. As long as the replacement beneficiary is a relative of the original beneficiary the tax advantages will not be disturbed.

Administration

There are many intricate rules and questions to be answered about the administration of these plans that go beyond the scope of this article. Any serious inquiry to a plan provider will get you complete literature on the plan and access to personal counseling as well. Each state plan has a designated provider of investment accounts with advisors available, either in person, by phone or e-mail.

Flexibility

Arizona has sponsored two or three designated investment managers. However you are not restricted to the use of these plans. In fact, Arizona will allow state tax-free eligible distributions even when using another state’s plan. Each State participates in an expense override that is negotiated with the investment manager and included in the investment manager’s total expense ratio, which is passed on to the investor. The more participants in the state plan, the more overrides that should come back. This national flexibility has emerged so that practically speaking, anyone can use any state plan and 529 distributions are accepted all over. Arizona allows tax-free distribution from any plan.

Investigation

An excellent source of general information can be obtained on the website

www.morningstar.com. Search for 529 information. One of their sources is "Ask the Professor" for five questions to ask about the 529 plan.

Another excellent website is www.savingforcollege.com. This can introduce you to state plans and contact points such as the Arizona Family College Savings Program (AFCSP) and the several investment managers that are available under their program. Many other state programs and connected investment managers can be identified for research purposes.

While there are many excellent programs available, it would pay to compare investment management firms and related program expenses. Some plans offer mandatory age-based portfolio diversification models while others offer self-directed or advisor assisted allocations.

You can go directly to some of the more popular investment manager websites such as www.fidelity.com, www.vanguard.com, www.troeprice.com, www.tiaa-cref.com, or www.americanfunds.com. Any manager you like will have a website that is easily accessible with links to various affiliated state 529 plans.

Caution

It is not clear how 529 plans will be treated for financial aid purposes. Money in these plans will almost certainly hurt aid eligibility, so be cautious about funding a 529 plan if you think you will qualify for aid. Even if Congress does write new aid rules that are favorable to 529 plans, the colleges may become aggressive in assessing this money because they may not want to give aid to families who do not really need it.

Concerning the Hope and Lifetime Learning education tax credits, which are available to couples filing jointly with modified adjust gross income of less than $82,000, if these credits are claimed you will not be able to make tax-free withdrawals to cover the same expenses.

Consider that if you are married, filing jointly with a modified gross income of less than $190,000 you can also fund a Coverdell plan with as much as $2000. At least with this money, you can buy any mutual fund you desire and it will probably be less expensive than even the lowest cost 529 plan.

Shop And Compare

All 529 plans are not equally worthy of your investment dollars. Serious flaws in some plans show up as limited investment choices and excessive management fees levied by some states and their investment managers. According to Austin Goolsbee in his "Moneybox" article entitled "The 529 Rip Off," he writes concerning expenses:

"Take one of the most egregious examples, Arizona’s InvestEd plan, operated by Waddell and Reed. Investing in its class "A" shares with the highest equity option, an investor must pay 92 basis points (0.92 percent of assets) per year for fund expenses and then another 91 basis points of state management fees. When you cash out, you have to fork over another 5.75 percent of total assets as a "sales load." The class "B" shares don’t take the 5.75 percent final cut, but the extra management fee is 162 basis points, meaning the state and Waddell and Reed grab a whopping 2.54 percent of your savings every year."

So, comparison-shopping for an efficient 529 plan is very worthwhile. Even the best plans with low expense investment management companies have expenses that are greater than their non-529 offerings, primarily because of the state management fees. One of the lower state management fees is in the Virginia program where only 10 basis points (0.10 percent of assets) is assessed back to Virginia. One of the lower overall expensed plans is offered though the Utah plan with Vanguard management, and even there the state management fee is 25 basis points. Some plans come with age-based allocations and some allow you and/or your advisor to determine the fund allocation. .

Remember that over time, the plan offerings may be revised and that you are allowed to change your plan, on a tax-free exchange once a year.

Good hunting!!!

Article by Ray Martin, CFP

Financial Directions, LLC

A Registered Investment Advisor