The cost of a college education can be staggering. Expenses at private universities currently average more than $22,000 a year. The annual cost for state colleges averages about $10,000. For many families, qualified tuition programs — also called Section 529 education savings plans — are an attractive way to help meet future education expenses. Now, the Economic Growth and Tax Relief Reconciliation Act of 2001 has made them even more appealing by allowing tax-free withdrawals.

How Section 529 Plans Work

Section 529 plans are education savings programs sponsored by most states under Section 529 of the Internal Revenue Code. Beginning in 2002, private educational institutions also will be able to sponsor prepaid tuition programs. You can contribute to a Section 529 plan regardless of your annual income or your age, and your contributions can be for the benefit of a grandchild, niece, or nephew, as well as your own child.

With a 529 plan, you either invest a lump sum or make periodic contributions to an account set up for a designated child. While different programs do place limits on lifetime contributions, most limits are in excess of $100,000, and some are greater than $200,000. The plan account is professionally managed according to an investment program you set up when you make your initial contribution. When the child is ready for college, generally you — not the child — withdraw the amount needed to pay qualified education expenses, such as tuition, room and board, supplies, and equipment.

Tax Advantages

Money invested in Section 529 plans grows free of federal income tax and possibly state income tax for participating residents in many states. Some states also allow you to deduct investments in Section 529 plans for state income-tax purposes, up to certain limits, if you participate in your own state’s program. In addition, the plan investment managers can move money between different investments as needed with no capital gains tax consequences, something you can’t do with a regular investment account.

Through 2001 for state-sponsored Section 529 plans and until 2004 for private qualified tuition plans, distributions or educational benefits are taxed to the student at his or her federal income tax rate, rather than your rate, which may be significantly higher. Starting in 2002, payouts from state plans will be tax free, and in 2004 payouts from all Section 529 plans will be excludable from income. These tax benefits are scheduled to expire at the end of 2010, unless further action by Congress is taken. (Note that after 2001 tax-free withdrawals cannot be used for the same expenses for which HOPE or Lifetime Learning Credits are claimed.)

Investments in Section 529 plans qualify for the federal gift-tax annual exclusion. This exclusion lets you make tax-free gifts of up to $11,000 a year ($22,000 if your spouse agrees to join in your gifts) to each of as many people as you choose. A special tax provision allows you to contribute up to $55,000 in one year and treat the contribution as if it were made over five years so it qualifies for the exclusion. So you and your spouse could contribute as much as $110,000 in one year for each of your children or grandchildren, free of gift tax.

The money you invest in a 529 plan, as well as all future appreciation on that money, generally is removed from your estate for estate-tax purposes. However, if you make the five-year/$55,000 election, and die within five years of the election, a pro-rated portion of the contribution will be included in your estate. Using the annual exclusion to make gifts to grandchildren has generation-skipping transfer (GST) tax advantages, too. No GST tax will be applied to contributions that qualify for the annual exclusion.

Portability

Starting in 2002, money can be transferred tax free from one qualified tuition program to another qualified tuition program for the same beneficiary. Other transfer rules vary from state to state. In case the designated child decides not to attend college, you have the option of changing the account beneficiary to another family member. Family members include the beneficiary’s spouse, siblings, first cousins, children, nieces, nephews, and their spouses. Take care, though, when changing beneficiaries. Gift and GST taxes could apply if the new beneficiary you name is a generation below the old beneficiary.

Financial Aid

On the minus side, a Section 529 plan account may adversely affect your child’s ability to qualify for need-based financial aid. Withdrawals from Section 529 plan accounts generally are counted as student income. Many aid formulas consider up to 50% of student income available for tuition. However, aid is often granted as loans, which you may want to avoid. Most families earning $100,000 or more qualify for very little need-based aid.

Choosing the Right Plan

To find out which states offer qualified tuition programs and get general information about them, check: savingforcollege.com or collegesavings.org. Refer to the program brochure or offering memorandum and prospectus for complete information on risks, fees and expenses. These documents should be read carefully before investing. Note that your choice isn’t limited to the program offered by your home state. Although non-residents may not receive the state tax advantages afforded to residents. However before choosing a plan, you should talk with a professional financial planner. He or she can help you evaluate the many programs available

Published: September 18, 2002

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David N. Chazin is a Financial Planner with Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor, 3000 Executive Parkway, Suite 400, San Ramon, CA (925) 659-0251. Email: dnchazin@LNC.com or Web: ChazinFinancial.com