BI > MAY 2003

An Update on 529 Plans

Tax Deductions for Losses Possible, But Be Careful

In December 2001 we wrote about Section 529 college savings plans. Since then there have been some developments that we thought you would be interested in learning about. But before going into these, let's first review the basic features of 529 plans.

There are two primary types of 529 plans: college savings plans and prepaid tuition plans. Both allow you to save toward higher-education expenses on a tax-deferred basis. There is no federal tax deduction for contributions to these plans, but most states offer some state tax benefits to residents. Contributions to these plans are treated as gifts and are subject to gifting rules. But large gifts -- up to $55,000 per individual or $110,000 for a married couple in 2003 -- can still be made gift tax-free over a five-year period.

Qualified distributions (see table, below) will be tax-free under current law through 2010, after which time the earnings portion of distributions will be federally taxable unless the current rules are extended. If you do not spend all the money in a Section 529 plan on the intended beneficiary, the unused money can be transferred to another beneficiary without penalty. The earnings portion of a nonqualified withdrawal is subject to income taxes and a 10 percent federal penalty tax unless the withdrawal is made because of the beneficiary's death or disability, or to the extent the beneficiary receives a scholarship.

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There are several important differences between the two types of plans that are important to understand as well. The table above summarizes some of these differences. All 50 states and the District of Columbia now offer 529 savings plans, expanding the array of choices. In addition, more savings plans have expanded their investment choices by offering individual mutual funds as well as the more traditional fixed portfolios of funds.

Several of our clients who have expressed interest in 529 savings plans have been under the impression that these accounts are only for large contributions, and they have therefore been discouraged from contributing. Each plan does set minimums, but they are modest -- generally $250 to $500 if you open an account with a lump sum contribution (or less if you set up automatic monthly drafts from your bank account). Once an account is open, most 529 savings plans will accept contributions as low as $25.

One strategy that works particularly well is when a parent or grandparent opens an account on behalf of a child. Then they or other family members or friends can add to the account whenever they please. Amounts can be added either periodically or regularly. For example, you can make a birthday or holiday gift to a child in the form of a contribution made directly to a 529 savings account, even if you are not the owner of the account.

Tuition Plan Consortium

Private organizations can now offer prepaid tuition plans from which tax-free distributions can be made starting in 2004. The Tuition Plan Consortium (TPC), a nonprofit organization, has developed the first such plan, which it has named the Independent 529 Plan. TIAA-CREF will be the new plan's administrator and investment manager.

Tuition certificates offered by the Independent 529 Plan will be honored by private colleges in the United States that choose to participate. Each participating school will make the certificate worth a certain percentage of its tuition cost; this percentage will differ from one school to the next. The good news is that each school will be required to discount its tuition price when setting its percentage. The TPC anticipates that several hundred private schools, including many Ivy League schools, will participate in the program and that the plan will be made available this summer.

Tax Deductions for 529 Plan Losses

Be careful before you try to take tax deductions for 529 plan losses. Because of the declining markets, many investors now find that they have a loss in their 529 savings plans. This loss can be claimed on your federal tax return as a miscellaneous itemized deduction if you fully liquidate the account.

This deduction may have limited value, however, since total miscellaneous itemized deductions must exceed 2 percent of adjusted gross income before they're eligible as deductions. In addition, higher-income taxpayers may have some of their itemized deductions phased out. Another tax disadvantage of this miscellaneous itemized deduction is that it isn't subtracted for alternative minimum tax (AMT) purposes. Guidelines for deducting 529 plan losses are given in the 2002 version of IRS Publication 970, Tax Benefits for Education, but we would recommend that you consult a professional tax adviser before taking any action.

While prepaid tuition plans have offered some protection against the market decline, these plans have been adversely impacted by the declining stock market as well, although in a different way. Many states now faced with budget deficits because of lower income tax revenue have found it necessary to increase the prices for new sales of prepaid tuition contracts. In fact, some plans are now charging a premium over current tuition prices in order to cover future tuition increases. Some prepaid plans are backed by the "full faith and credit of the state," but not all of them are. Therefore, it's wise to investigate the financial condition of a state before investing in its prepaid tuition plan.

As states gain more experience with 529 plans, they are revisiting the state tax treatment of these plans and are using these tax rules as a means of competing with out-of-state plans. For example, if you're an Illinois resident, the earnings portion of a qualified withdrawal taken from another state's plan is subject to Illinois taxes starting in 2002, even if the distribution is completely free from federal taxation.

Starting in 2003, New York taxpayers will be taxed on the earnings portion of a qualified "tax-free" rollover from a New York 529 plan to another state's 529 plan. (This is in addition to the recapture of any deductions taken for contributions made to a New York plan.) Changes such as these are becoming commonplace, so it's necessary for you to stay current regarding the rules for the state or states in which you pay taxes.

Possible Changes in the Higher Education Act

Finally, the Higher Education Act is up for reauthorization. While this act governs and is focused primarily on financial aid issues, the rules regarding 529 plans and other education tax incentives may be affected as well.

For example, the College Board, a national nonprofit association composed of schools, colleges, universities and other educational organizations, has recommended treating prepaid tuition plans as the parent's asset for financial aid purposes so that these assets will be assessed at a relatively low rate. (Currently, distributions from prepaid tuition plans reduce financial aid eligibility dollar for dollar.) This would remove one of the disadvantages of prepaid tuition plans when compared with 529 savings plans. The Department of Education has also announced that it's seeking "innovative and creative" ways for the government to integrate tax incentives with federal financial aid programs.

Section 529 plans are very attractive, but they're also quite complex when you consider that each plan has its own rules, costs and investment choices. Every state has its own set of rules for taxing these plans. Furthermore, the rules keep changing. If you want to do research on 529 plans, we think the best source is www.savingforcollege.com, a Web site devoted to the subject. This site offers the latest news and provides current information on every 529 plan available.

As always, whether you already have a 529 plan or are considering investing in one, we think it's important to consult your financial planner for advice specific to your situation before taking any action. Make sure that your planner is informed in this area, however.

In recognition of the fact that college financial planning has become more complex, a new designation called the Certified College Planning Specialist (CCPS) was created in 2002. This designation is awarded by the National Institute of Certified College Planners to financial advisers who successfully complete a comprehensive training program and demonstrate competency in college planning.

As of February 2003 only 100 financial advisers held this designation. But we suspect the number will grow rapidly as changes continue to occur.

Alexandra Armstrong, a Certified Financial Planner practitioner, registered representative with FSC Securities Corporation, registered broker dealer and member NASD/SIPC, is chairman of Armstrong, MacIntyre & Severns, Inc., a registered investment advisory firm in Washington, D.C.

Individuals should contact a financial planner, tax adviser or attorney when considering these issues. Ms. Armstrong cannot answer individual inquiries, but welcomes suggestions for future article topics.