IRC Section 529 plans (“529 plans”) permit parents – or anyone else – to establish and fund an account administered by individual states to pay future college expenses. Like a Roth IRA, contributions are not deductible, but neither is investment return taxed when used for qualified higher education expenses. Previously, the earnings component was taxable to the child when distributed. However, under the 2001 Tax Act, qualified distributions will also be tax-free as of January 1, 2002. Many states, including New York, also impose no income tax on qualified withdrawals. Under the Act, contributions may now be made to both an Education IRA and a 529 plan without an excise tax.
Thirty-five states currently have 529 plans, which are generally open to nonresidents. However some states, including New York, offer income tax incentives only to residents. New York allows an annual $5,000 income tax deduction ($10,000 for a couple) for contributions. New York’s plan, considered excellent, is administered by TIAA, which imposes an annual management fee of 0.65% on net asset value. TIAA, which manages over $280 billion in assets, has also been chosen to manage twelve other states’ plans. (www.nysaves.org; 877-697-2837). Fees range from that of Utah, 0.31%, to that of Oregon, 2.24%.
Most states’ 529 plans permit multiple accounts to be opened by multiple account owners for a single designated beneficiary. However, no more than $100,000 may be contributed to all accounts for one beneficiary in New York. Moreover, once the account balance reaches $235,000, no more contributions may be made regardless of whether the $100,000 threshold has been met. No age restrictions are placed upon who may be the beneficiary of a 529 plan: a parent can open an account for a high school age child or even for himself or herself. However, at least 36 months must elapse before taking qualified withdrawals.
Most states’ plans have multiple investment options. For example, New York now has four investment options: (i) one guaranteeing a 3% rate of return; (ii) two age-based managed allocation options which shift from stocks to bonds as the child nears college age; and (iii) one high equity option. Federal law prohibits changing an investment option. To overcome this limitation, new investments in new plans may be made with a new investment option. Alternatively, an account can be rolled over to another state’s plan; of course, individual state tax benefits may be lost.
529 plans compare favorably to trusts created under a state’s UTMA to pay for college expenses. UTMA assets must generally be distributed at age 21. In contrast, 529 plan assets need not be distributed unless the child matriculates college. It appears that UTMA funds may be rolled over into a 529 plan.
If no matriculation occurs, the funds can be rolled over without adverse tax consequences to another “family member,” which is broadly defined to include even parents and first cousins. If the child dies or becomes disabled, funds can also be withdrawn without tax or penalty. However, if no matriculation or rollover occurs, federal and New York state income tax will be imposed on the earnings portion of the “nonqualified distribution,” together with a 10% penalty on those earnings.
Qualified higher education expenses generally include tuition, fees, supplies, books, and equipment required for enrollment. Most room and board expenses are also covered. However, qualified expenses will be reduced by expenses used to claim tax credits, and by scholarships or allowances.
The tax-free compounding within a 529 plan is most advantageous to higher bracket taxpayers. While lower tax bracket taxpayers will also benefit from tax-free compounding and distribution, extra caution must be exercised if the child may apply for need-based financial aid. Plan assets are considered parents’ assets until money is withdrawn. At that point hey are considered student assets. Accordingly, a 529 plan may be unattractive for a child who might otherwise qualify for aid. Nevertheless, 529 plan assets will not be considered in determining the eligibility for New York State-administered financial aid programs.
Contributions to 529 plans are also treated favorably for federal gift tax purposes. Up to $50,000 ($100,000 for a married couple) may be contributed without current gift tax consequences, provided the gift is spread over five years. 529 plans therefore compliment an estate plan which seeks to maximize gifts at little or no transfer tax cost. [New York repealed its gift tax effective January 1, 2000.]