Saving for Education

529 Savings Plan
The 529 savings plan allows investors to save/invest in education. Usually, it is a family member putting money away for a child's education, but the beneficiary does not have to be a child or even a blood relative of the donor. In fact, an individual can set up a 529 plan for him or herself. The person who opens the account is the owner. The beneficiary is the person who will use the money for education. For 529 savings plans, the owner controls the assets.

Contributions are made after-tax (non-deductible), but the withdrawals used for qualified education expenses are tax-free at the federal level. Notice how we said, "federal level." The plans are state-specific so some states may tax the withdrawals. That means that if Grandma lives in New Jersey and buys a Wisconsin plan, New Jersey could end up taxing the money that the grandkids use for college. Then again, New Jersey might allow Grandma to deduct her contributions for purposes of state income taxes. So, you don't want to buy into a 529 savings plan without first checking how it will be taxed by the state.

And, even with federal taxation, the withdrawals for education must be qualified withdrawals that cover tuition, room & board, books, etc. The expenses must be directly related to education; otherwise, the account owner will be subject to a 10% penalty plus ordinary income tax on any earnings are withdrawn. If the beneficiary decides he doesn't need the money, the account can name a second beneficiary without tax problems, if the second beneficiary is related to the first.

And there is one area that can lead to confusion. When setting up a 529 plan, it makes no difference whether the account owner is related to the beneficiary. It's just that if an individual starts a 529 plan for a beneficiary and then discovers that the child has no intention of going to college, then if he wants to avoid tax implications, he can only change the beneficiary to a blood relative of the beneficiary. If he wants to change beneficiaries to someone not related, he would have to deal with the 10% penalty and ordinary income tax ramifications.

When the donor is putting money into a 529 savings plan on behalf of her grand¬daughter, she is making a gift. Gifts over a certain amount are taxable to the one making the gift. With a 529 savings plan, this grandmother can contribute up to the gift tax exclusion without incurring gift taxes, and can even do a lump-sum contribution for the first five years without incurring gift tax hassles. In other words, if the annual gift tax exclusion is $14,000, she can put in $70,000 for the next five years. If she and Grandpa are married-filing-separately, they could put in twice that amount, or $140,000, without any gift tax issues. Note that if someone uses the five-year-up¬front method, they can't make any more gifts to the beneficiary for the next five years without dealing with gift taxes.

Each plan has a maximum lifetime contribution limit, rather than an annual limit.

The owner of the plan maintains control over the assets, deciding when withdrawals will be made. The money can be withdrawn to cover higher education expenses, such as tuition, books, and room and board. College is one type of institution covered by these plans. Vocational schools are another.


Prepaid Tuition
If you're sure that Junior won't mind going to college in-state, you might want to lock him in as a future Boilermaker, Hoosier, or Sycamore through a plan whereby you pay for his tuition credits now for any public school in the fine state of Indiana. I didn't say you were locking him into being accepted at IU or Purdue, but he would get to go to a state school with a certain number of credits already paid for. Parents worried about the ever-rising cost of tuition, then, can pay today's prices and redeem the credits more than a decade into the future.

These tuition credits cover tuition and fees only. If the child gets a scholarship or doesn't need the money because of something tragic like death or disability, a refund is typically provided plus a modest rate of interest. The exam could refer to prepaid tuition plans as "defined benefit plans." You pay for the tuition credits now, and then you hope the state can afford to provide the benefit of education when your child needs it.

Coverdell Education Savings Account
A Coverdell Education Savings Account (CESA) also allows for after-tax contributions (non-deductible), but the current maximum is only a few thousand dollars per year per child. While the 529 Plan is for higher education only, the Coverdell plan can be used for elementary, secondary, and higher education expenses. The distributions are tax-free at the federal level if used according to the plan guidelines. As with the 529 plan, the Coverdell ESA account can be used for education expenses, including tuition, books, and room and board. In a Coverdell, contributions must stop on the beneficiary's 18th birthday, and the assets must be used for education or distributed to him by age 30. Also, there are income limits on the donors of a CESA, like the limits placed on people trying to fund their Roth IRAs.
So, should you use a 529 plan or a CESA? Generally, it would come down to the amount of money you want to contribute. If you're going to contribute only a few thousand dollars, you might as well use the CESA. If you want to put large sums away, you'll have to use the 529 plan. Both way, you’ll get tax deferral and tax-free withdrawals at the federal level, assuming you do everything according to plan.