College Tuition Planning and Wealth Management

Using 529 Plans to Invest for College and Manage Wealth

Paying for a child’s or grandchild’s college education is an expensive proposition, even for many high-net-worth Americans. Today’s elite institutions promise graduates a rewarding future, but at a cost that more often than not extends well into six figures. Enter the 529 plan, a tax-advantaged investment vehicle generally available to families regardless of their income level. For affluent parents and grandparents, a 529 plan offers a variety of potential benefits — including some that go beyond the scope of college planning. A 529 plan may in fact play an integral role in an estate plan.

Named for the section of the Internal Revenue Code that authorized them, 529 plans allow investment earnings to grow sheltered from federal income taxes, and withdrawals used to pay for qualified education expenses are tax free. But for parents or grandparents concerned about estate taxes, 529 plans may be even more valuable, supporting a long-term gifting strategy while still providing significant control over assets that have been removed from a taxable estate.

First and Foremost, a College Savings Tool…
Before you consider the potential role of a 529 plan in your estate plan, it’s important to understand a few basics.

There are two types of 529 plans — prepaid tuition plans, which let you lock in tomorrow’s tuition at today’s rates, and college savings plans, which let you choose from a menu of investments and offer more return potential, as well as risk. Both types of plans are generally sponsored by a state government (although tax law permits certain educational institutions to sponsor prepaid tuition plans) and administered by one or more investment companies.

With a 529 college savings plan, the underlying investment options are typically managed by mutual fund companies. Many plans offer age-based asset allocation portfolios that become more conservative as the beneficiary grows older. Others let account owners choose from individual investment options to create a customized portfolio.

Originally, 529 plans offered the benefit of tax-deferral — taxes on earnings weren’t due until withdrawal and then only at the beneficiary’s rate. But qualified withdrawals are now federally tax free.

Eligibility to contribute to a 529 plan is not limited by age or income. In addition, total plan contribution limits often exceed $200,000.

Withdrawals can be used to pay for undergraduate or graduate school expenses. Withdrawals for purposes not related to paying qualified education expenses are subject to ordinary income taxes and a 10% penalty tax.

Finally, remember that you are not limited to participating in your home state’s 529 plan — you can participate in national plans sponsored by other states as well. Be aware that your home state’s 529 plan may have state income tax consequences. Consult with a tax advisor before investing in a plan.

…But With Valuable Estate Planning Potential
The IRS clearly had college planning in mind when it drafted Section 529 of the Internal Revenue Code. However, it also left the door open to use 529 plans as estate planning tools. That’s because a contribution to a 529 plan is considered a completed gift from the donor to the beneficiary named on the account, even though the account owner, not the beneficiary, maintains control over the money while it’s in the account. Tax rules permit you to give $12,000 (indexed to inflation) to as many individuals as you choose each year, free from federal gift taxes. Couples can give $24,000 without incurring taxes. As a result, one method of reducing a taxable estate is to make scheduled gifts up to the tax-free limits each year. You might give $12,000 to each grandchild on an annual basis, for example.

That’s where 529 plans come in: The first $12,000 you contribute each year per beneficiary won’t come back to bite you, as long as you haven’t made any additional taxable gifts to the beneficiary in that year. You can also accelerate your gifting schedule by electing to make a lump-sum contribution of $60,000 to a 529 plan in the first year of a five-year period ($120,000 for a couple). Of course, you wouldn’t be able to make additional taxable gifts to that beneficiary during the five-year period. And if you use the five-year averaging election and die before the five years are up, a prorated portion of the contribution may be considered part of your taxable estate.

But the wealth transfer potential can be substantial: An individual who has five grandchildren could immediately remove up to $300,000 from his or her taxable estate by contributing the money to five separate 529 plan accounts. Five years later, he or she could do it again.

Smart Shopping: Making the Right Decision
If you decide that a 529 plan deserves further consideration, keep in mind that there are often important differences between the plans offered by each state. For example, lifetime contribution limits can vary widely from state to state. The limits are often based on average college costs within the sponsoring state. In calculating those averages, some states assume that not just undergraduate expenses are incurred, but graduate expenses as well.

Also, some plans offer relatively few investment options, while others may give you a wide range of investment choices managed by specially selected sub-advisors. Evaluate the performance of the investment options offered by specific plans. Compare the fees and expenses each plan charges too. And finally, keep in mind that some states offer in-state residents a tax deduction when they make a 529 plan contribution.

You Stay in Control
It’s worth emphasizing: Although the assets contributed to a 529 plan are no longer considered part of your taxable estate, you still exercise control over the money. You decide how it will be invested — within the confines of the plan’s available investment options — and when it will be withdrawn. You also have the right to change beneficiaries, in the event that the original beneficiary decides not to attend college, for example. And doing so generally won’t trigger tax consequences if you choose a beneficiary who is a member of the original beneficiary’s family. (As spelled out in Section 529, qualified family members include the beneficiary’s brothers or sisters, mother or father, sons or daughters, and nieces or nephews, among others.) If there isn’t another suitable beneficiary, you also have the option of closing the account and taking the money back, although earnings will be subject to income taxes, as well as a 10% penalty.

When choosing a 529 plan, you’ll need to look beyond estate planning considerations. There are dozens of plans available and their features and rules can vary greatly. To help narrow down the choices, consider working with a qualified financial professional. And be sure to consult with an estate planning attorney or tax professional before making any decisions that could affect your tax liability.

Points to Remember
1. State-sponsored Section 529 college savings plans have the potential to double as high-powered estate planning tools. Any assets you contribute to a 529 plan account are removed from your taxable estate and pass into the plan free of federal gift taxes, up to an annual limit of $12,000 ($24,000 per couple.)
2. The IRS will allow you to make five years’ worth of tax-free gifts in one year, but only once every five years. That means you can contribute up to $60,000 at once ($120,000 per couple), helping to finance a beneficiary’s education while simultaneously minimizing potential estate tax obligations.
3. Although the assets gifted to a 529 plan are removed from your estate, you retain control over investment, withdrawal, and beneficiary decisions.
4. 529 plan contributions and investment earnings can be withdrawn tax free as long as the money is used for qualified education expenses. If you make withdrawals for non-education purposes, you must pay ordinary income taxes and a 10% penalty.
5. Shop wisely before selecting a 529 plan. For example, compare fees, investment options, and lifetime contribution limits.

Securities offered through LPL Financial, Member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, a registered investment advisor.

Copyright © 2008, Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved.

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