Studying up on 529 college savings plans

Two types of savings plans provide families with tax-saving strategies that also benefit their children and grandchildren. College savings plans and prepaid tuition plans are what are known in the tax community as 529 plans. These vehicles have much higher contribution limits than those for other tax-advantaged educational savings plans.

Both types of plans are worth considering. Which one you select will depend on your investing preferences and other factors.

States or institutions sponsor college savings plans

College savings plans are sponsored by states, state agencies or certain educational institutions. Offered in nearly every state, these plans allow you to make cash contributions to a tax-advantaged investment account.

Although contributions to a 529 plan aren’t tax deductible at the federal level, earnings may be withdrawn free of federal and sometimes state income taxes, provided they’re used for qualified higher education expenses. These include tuition, fees, books, supplies and equipment, and certain room and board expenses. Nonqualified withdrawals are subject to taxes and a 10% penalty on the earnings portion.

Although most college savings plans are open to both residents and nonresidents of the state sponsoring the plan, there may be advantages to opening an account in your home state. For instance, many states offer state income tax deductions or other tax breaks that are available only for residents.

Prepaid tuition plans: A hedge against tuition hikes

Prepaid tuition plans allow you to purchase tuition credits based on current prices as a hedge against future tuition increases. They can be an attractive option for more conservative investors or those whose children are older and have a short investment horizon.

Many of these plans are for tuition only, although some cover room and board. Once you invest in prepaid tuition credits, the cost of purchased quarters, semesters or years are guaranteed, regardless of what happens to tuition prices or in the stock market. You’ll likely have to pay a premium over current tuition, however, so if you’re looking at this as an investment, expect your returns to be modest at best.

In addition, you’ll be limited to certain schools. Some plans allow you to use your credits at private or out-of-state schools, but there’s no guarantee that they’ll be sufficient to cover the tuition. Other plans let you withdraw your contributions, plus modest interest, to use at other schools.

Both plan types share advantages

Contribution limits vary among 529 plans, but generally range from $150,000 to more than $350,000 per beneficiary.

While 529 plans are designed to fund college expenses, they also provide estate planning benefits. Contributions are considered completed gifts for purposes of gift and generation-skipping transfer (GST) taxes, but they’re also eligible for the annual exclusion, which currently shields up to $14,000 per year ($28,000 for married couples) in gifts, to any number of beneficiaries, from gift and GST taxes without using up any of your lifetime exemption.

What’s more, a 529 plan allows you to “front-load” contributions. This means that you can use up to five years’ worth of annual exclusions in one year. Suppose that a husband and wife open 529 plans for their two grandchildren, and that each plan has a $150,000 contribution limit. The couple can immediately contribute $140,000 (5 × $28,000) to each plan free of gift and GST taxes.

Two caveats: First, if you front-load contributions, you can’t make additional annual exclusion gifts to those beneficiaries for five years. Second, if you die within five years after making these contributions, a portion will be included in your taxable estate.

For estate tax purposes, 529 plans are an appealing tool because contributions and future earnings are excluded from your taxable estate despite the fact that you retain a great deal of control over the funds. Typically, you can’t place assets beyond the reach of estate taxes unless you relinquish control (by placing them in an irrevocable trust, for example). But with a 529 plan, you retain the ability to time distributions, to change beneficiaries or plans (subject to certain limitations), or even to revoke the plan and get your money back (again, subject to taxes and penalties).

The trend is on your side

There’s a current trend among many states to increase the tax benefits for contributing to 529 plans. Check with your tax attorney or CPA about your state’s laws with respect to 529 plan contributions. •