The ins and outs of 529 plans
Whether your children are toddlers or teenagers, 529 college savings plans are an option worth investigating, according to the Minnesota Society of CPAs (MNCPA). All states offer some form of 529 plan, an investment that makes it possible to set aside money for college that will grow tax deferred while in the plan but is also tax free when withdrawn to pay for qualified education expenses. Parents, grandparents or family friends-"”anyone, in fact--can set up a 529 plan.
529 plans defined
529 plans allow families to save money for college without paying tax on their distributions. If, for example, in 2007 you make a $10,000 distribution from the plan, it is excludable from income to the extent used for qualified educational expenses. This means that taxes on earnings within the plan are not only tax-deferred while in the plan, but also are tax free when withdrawn.
How they work
All of the states and the District of Columbia offer 529 plans. Many people mistakenly believe they can only be used to pay for colleges in the plan's home state or for a specific state university. In fact, there are no such restrictions for 529 savings plans. You can use all the money in your account at any eligible institution. Another 529 option, a prepaid tuition contract, makes it possible to lock in the current tuition at a specific public university (and some private colleges). You can also use your prepaid tuition contract funds at other schools, but some restrictions may apply.
Evaluate your options
With most 529 plans, you can select stock or bond funds offered by investment companies that are chosen by each state. Contributions can be made by parents as well as grandparents or other relatives or family friends. If the account is opened by someone other than the student, the money is not considered the student's asset. That's an advantage if the student applies for federal financial aid, because the fewer assets the student has, the more aid he or she is likely to receive.
You can invest in any state's plan, but you may miss out on state tax advantages if you pick a plan outside your state. At the same time, each state plan's performance will differ, so an out-of-state choice may be a better investment. It can be tough to compare your choices, because all of the states' plans have different investment options and fees. Your CPA can help you pick the best one.
A few caveats
What happens if your child does not go to college? There is a 10% penalty on earnings that are withdrawn from a 529 plan but not spent on qualified expenses. The amount you withdraw is also subject to federal and possible state income taxes. The penalty is not applied to withdrawals of your original deposits, but only to any interest or income earned on that amount. The penalty also doesn't apply if the intended beneficiary receives a scholarship and the withdrawal is not more than the amount of the scholarship, or if the beneficiary dies or is disabled. Finally, you can change the beneficiary to any other qualifying family member. If one child decides to postpone college, you can transfer the account to another child, for example.
Of course, while plan fees may have fallen, you should investigate administrative and other expenses when choosing a 529 plan, as you would with any investment.
Know your options
529 plans are a good vehicle for college savings, but they aren't the only one. Other tax-advantaged choices include Coverdell accounts and custodial accounts for minor children (also know as UGMA and UTMA accounts). Your CPA can explain each one to you and help you decide which is right for your situation.
Information and resources are available to the public on the MNCPA Web site (www.mncpa.org/information) including state and federal tax forms and information and financial planning information for individuals and small businesses. A free CPA referral service is also available on the Web site or by calling 800-331-4288. The MNCPA is part of the national 360 Degrees of Financial Literacy campaign to help Americans' improve financial literacy; information and resources are available at www.mncpa.org/360.