Updated: May 3, 2013 12:14PM
Originally published: August 7, 2001
One of the most positive changes in the new tax law is the benefit for anyone helping to pay for someone’s college tuition--parent, grandparent, guardian, mentor. I’ve long recommended these tax-free plans, called Section 529 plans, as the best way to save for college--and now they’re even more attractive. Here’s an update.
Section 529 college investment plans were authorized by Congress four years ago as the complement to state-organized prepaid tuition plans. While prepaid plans offered guarantees as to the ultimate value of the account, these Section 529 investment-type plans involve a degree of risk.
How 529 plans work
Section 529 plans allowed parents--or grandparents, family members or friends--to invest up to $50,000 a year in an account designed to pay future tuition for a child. In reality, most 529 accounts have been started with far smaller amounts. Many plans have initial minimums of $500 or $1,000, and will arrange for automatic investments of as little as $50 or $100 a month.
Section 529 plans have been organized by individual states in association with investment management companies, which offer a series of mutual fund choices. Most plans have taken the guesswork out of investing by crafting risk-based, age-appropriate mutual funds, depending on the age of the child for whom the account is opened. As the child gets older, the funds automatically invest in lower-risk securities.
Money can be withdrawn to pay for any college tuition or fees at a school in any location. While some state plans give additional breaks for residents, the flexibility of the plans means you could choose any state’s plan based on the investment choices and track records of the funds offered within the plan.
While investments in a Section 529 plan are not deductible, they have been very attractive for several reasons. First, the person who puts the money into the account retains control over it. Unlike custodial accounts under the Uniform Gifts to Minors Act, the money in a Section 529 plan does not automatically become property of the child at age 18.
Second, the contributor can actually take the money back at any time by paying a small penalty and appropriate taxes on the investment gains upon withdrawal. That feature has been attractive to wealthy grandparents, who’ve wanted to get assets out of their estate--but feared that economic circumstances or health problems would create a need for the money in the future. With a Section 529 investment plan, they can get the money back if their needs are more pressing than their grandchildren’s educational needs.
Third, the assets in a Section 529 plan do not count as an asset of the student in financial-aid formulas. Student assets weigh seven times more heavily against the family in the aid formula. In fact, many schools do not count these assets at all when considering grants of student financial aid.
The fourth advantage has just taken a quantum leap. Previously, withdrawals to pay for educational expenses were taxed at the student’s low income tax rate. Now, under the new tax bill, withdrawals from 529 plans will be completely tax-free!
What to do
If you’re willing to take some investment risk, this would be a good time to check out Section 529 investment plans for at least a large portion of your college savings. More conservative parents could invest some money in a 529 plan and put the balance in a prepaid tuition plan, or U.S. savings bonds, which give tax advantages to middle income parents who buy the bonds in the parent’s name and cash them in to pay for college tuition. Then keep making regular additions to each investment.
In Illinois, the prepaid tuition plan is CollegeIllinois! ( www.collegeillinois.com ). The Illinois Section 529 investment-type plan is BrightStart.
But you can find a list of all the existing Section 529 investment plans--and their investment choices and strategies--by going online to www.collegesavings.org
A terrific college savings opportunity just got better because it’s now tax-free. You have only yourself to blame if you procrastinate. And that’s The Savage Truth.
Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil-Quaker State Co. Send questions via e-mail at firstname.lastname@example.org. Her third book, The Savage Truth on Money, recently was published by John Wiley & Sons Inc.