The CPA Journal

By Sonja Lepkowski, CFP, CPA, Yohalem Gillman & Company LLP

Starting in 2002, the rules for the increasingly popular IRC section 529 college savings plans have become more flexible and generous. The program lets the assets the investor sets aside for college or other higher education grow free of federal and most state taxes. The investor controls when withdrawals take place. A limited range of investment strategies and options are available. In many plans, the investment allocation will usually shift as the child ages. The account owner can select among different investment strategies and can transfer contributions to another investment option once per calendar year, or upon a change of the designated beneficiary. The key is finding the right 529 plan for an individual’s higher education funding goals.

Contributions

There are no restrictions for account owners based on age, income, or state of residence. Maximum contributions differ from state to state (Florida is the highest at $283,000). In New York, contributions cannot exceed $100,000 per beneficiary, although the total value of the account can continue to grow until it reaches $235,000. Contributions are treated as completed, present-interest gifts, which qualify for the $11,000 annual gift tax exclusion in 2002. A special election allows a $55,000 gift, or $110,000 for a married couple filing a joint tax return, to be treated as if it were made over a five-year period, free of gift tax. If the gifts use up the annual exclusion, contributions to a 529 plan will eat into the $1 million unified credit. There are gift tax implications in transfers if the new beneficiary is not a family member or not of the same generation as the original beneficiary. Once the contribution to a 529 plan is made, it reduces the taxable estate. However, if the five-year election is made and the account holder dies before the end of the five-year period, that portion of the contribution allocable to years beginning after death is includable in the account holder’s gross estate, but not subject to estate tax.

Each account must be established by one person—spouses cannot open a joint account—but separate accounts can be opened for the same beneficiary.

Eligibility

In New York, only individuals can be account owners. In other states, including Connecticut, any U.S. citizen, resident alien, trust, corporation, or partnership with a taxpayer identification number may open an account. However, if the account is opened by a trust, corporation, or partnership, the gift tax annual exclusion is not available.

Children, grandchildren, spouses, relatives, someone unrelated, or the account owner can be a beneficiary. The beneficiary may be of any age in most states (including Delaware, New Jersey, and New York), but must be an individual, not a trust or other entity.

Qualified expenses include tuition, room and board (for students living on or off campus), books, and certain other fees and expenses at an eligible educational institution. Certain necessary expenses for special needs students will also qualify.

Withdrawals

Many states set no time limit on when the 529 savings must be used. In New York, after the account has been open for 36 months, the account owner can withdraw money without penalty to pay for the qualified higher education expenses of the beneficiary. Beginning in 2002, all qualified withdrawals from a 529 plan will be federal income tax–free. If the money is not used to pay for costs associated with an eligible educational institution, the withdrawal will be considered nonqualified and subject to a 10% penalty on the distributed earnings. In addition, taxes will be assessed on the earnings at the applicable tax rate. To avoid a federal 10% surtax one must roll over the account into another state plan that has eliminated the penalty before taking the nonqualified distribution.

N.Y. State Tax Advantages

A New York State 529 plan offers a tax deduction on contributions of up to $5,000 per year, in the aggregate for all contributions to all accounts of the account owner from his New York income. A husband and wife filing jointly can deduct up to $10,000 per year, made by either spouse even if only one spouse has New York adjusted gross income. All qualified withdrawals from a New York 529 plan will also be income tax–free.

Other Factors

Since earnings on 529 plans are now tax-free for federal and most state purposes, one might want to convert a UGMA/UTMA account into a 529 plan. Tax will be due on any appreciation held in the UGMA/UTMA account that must be converted into cash to set up a 529 plan. However, such a 529 plan will be owned by the child and, in New York, the child, not the parent, will get the deduction.

A transfer from one 529 plan to another for the same beneficiary will no longer be considered a taxable transfer; neither will changing the beneficiary to another family member. This allows for greater portability of college savings assets and increased flexibility to select among program providers. Contributions may now be made to both a Coverdell Education Savings Account, formerly known as an Education IRA, and a 529 plan. Hope and Lifetime Learning credits can be claimed in the same year as tax-exempt distributions from a 529 plan, as long as they are not used to pay for the same educational expenses. A 529 plan is considered the parent’s asset until the money is withdrawn. Gains from a 529 plan are considered the student’s income, up to 50% of which is available to pay tuition.

There are other negatives. Section 529 plans are not guaranteed by the government or a bank, and may lose value. Also, the ability of creditors to reach the assets of a qualified savings plan varies from state to state and can pose a serious risk.

Alternative 529 programs. A for-profit college-savings network called Upromise.com offers ways to save while paying routine bills, shopping at dozens of stores, eating out, traveling, buying gas, and more. The participating vendors will give rebates ranging from less than 1% up to 10% of the purchases, and apply them to a college savings account earmarked for a beneficiary. The program is set up for parents, grandparents, and other relatives and friends to pool their rebates for any child’s education fund. Some of the leading financial services firms manage the accounts. Upromise estimates that over a 15-year period a typical family of parents and grandparents can save $20,000.