Picking the Right College Savings Plan
June 4 -- Picking the right tax-free state college savings plan can be almost as daunting as picking the right college. At last count, 46 states sponsored one of these plans, most run by financial services companies and open to residents of all states.
Each plan has its own set of fees, investments and rules. But all share a powerful attraction: Under Section 529 of the tax code, money put in them grows tax-deferred and can be withdrawn federally tax free so long as it's used to pay college costs.
The 529 plans also have two unusual estate/gift tax advantages of particular interest to grandparents. First: Money contributed to a 529 is out of your estate. But so long as you're listed as the owner, you can still take it back if you need it, by paying taxes at your ordinary income tax rate, plus a 10 percent penalty, on the earnings you withdraw.
Second: Normally you can't give another person more than $11,000 a year without its counting against your $1 million lifetime exemption from gift and estate taxes. But you can stash $55,000 at once in a 529 and count it as five years' worth of $11,000 gifts.
With tax breaks like these, if a family isn't likely to qualify for college financial aid (see box), deciding to invest in a 529 is easy.
Far more difficult, however, is figuring out which plan to use and what to put in it. Until late last year this was mostly a one-time decision — once you picked an investment option for a 529 plan you were pretty much stuck with it, unless you were willing to engage in some fancy maneuvers, such as switching beneficiaries while rolling the account from one state plan to another. But Congress and the IRS have loosened the rules, and now you can adjust your investment allocation once a year, without changing the named beneficiary or the state.
Do’s and Don’ts
Some do's and don'ts for college savings plans:
Do check if you get a deduction for contributing to your own state's college savings plan.
Do — to get more tax savings — treat a 529 as part of your total portfolio and put taxable bonds into it.
Don't ignore big fees. Many broker-sold plans charge high loads and annual expenses.
Don't forget to make sure you aren't likely to qualify for college financial aid before funding a 529 plan.
That, combined with an explosion of investment choices within 529s, gives parents and grandparents an opportunity to treat their 529 holdings as part of their total portfolio — and to squeeze more tax benefits from them.
Consider: The most popular option among 529 investors is an "age-based" portfolio that mechanically shifts asset allocation from mostly stocks to mostly bonds as a child approaches college age. But many families can wring even more tax savings from a 529 by investing it all along in taxable bonds — whose interest would otherwise be taxed at a federal rate of up to 40 percent (including the effect of an itemized deduction clawback) — and holding index funds or individual stocks in their taxable accounts, says Yale School of Management professor Matthew Spiegel.
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