To hear the hype, you'd think that 529 savings accounts were the greatest invention since the GI Bill when it comes to covering college costs.
The hype is mostly right. The state-sponsored plans provide shelter from federal and state income taxes, give grandparents a good way to chip in for their grandkids' education, and do little damage to your chances for financial aid. In more than half of the states, they also deliver a state tax deduction or other tax benefits in exchange for your contributions.
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So enticing are the programs that savers have finally awakened to their appeal. Assets in 529 plans totaled almost $97 billion at the end of the first quarter of 2007, up 30% compared with the same period in 2006, according to the College Savings Foundation. The average account balance approaches $12,000, which is about equal to the total cost of one year at a public college or university.
Still, if you rely too heavily on 529s, you could end up with more money in the accounts than you have to pay in qualified college costs -- which would trigger the very tax you were trying to avoid. "The 529 is one great option, but it should be used in moderation," says Deborah Fox, of Fox College Funding, a network of financial planners.
Lots of pluses
Created by the section of the tax code that also gave life to prepaid-tuition plans, 529s let your savings grow tax-deferred and escape tax altogether if you use the money for qualified educational expenses, such as tuition, fees, books, and room and board. If your child takes a pass on higher ed, you can transfer the funds to another family member and preserve the tax benefits. Or you can withdraw the money yourself and pay income tax and a 10% penalty on the earnings. Unlike other education savings programs, 529s let families participate regardless of income, and the states set a high ceiling on contributions.
The plans also represent an opportunity to help the grandkids and move money out of your estate. You can put up to $12,000 annually into a 529 plan for each child (or $24,000 if your spouse joins in the gift) without incurring the federal gift tax. Or you can drop $60,000 ($120,000 per couple) into the account at one time and average the gift over five years. If one grandkid bails on college, no problem. You simply switch the money to another.
Parents don't have to worry that a 529 will seriously affect their financial-aid potential. The federal financial-aid formula assesses parent-owned accounts at 5.6%, a relatively painless hit compared with the 20% assessment on student savings. The federal financial-aid application (FAFSA) doesn't ask about grandparent-owned accounts at all.
Starting next year, if a child has unearned income of more than $1,700 in a regular custodial account, it will be taxed at the parents' rate for dependent full-time students under age 24. That tightening of the "kiddie tax" rules makes custodial accounts less appealing and 529 plans all the more attractive.
But when it's time to take money out of your 529, make sure your withdrawals match up with qualified college expenses, says Rick Darvis, a certified college financial planner in Plentywood, Mont. If withdrawals exceed expenses, the portion of the excess that represents earnings are considered unearned income to the beneficiary -- your student -- and are taxed accordingly. "Before, it didn't make much difference because you didn't withdraw the money until the student was in college and the student's presumably lower tax rates applied," says Darvis. "Now, the kiddie tax applies during the college years."