Do your homework on 529 plans. (Personal Finance).

In 2002, many of us saw our investment returns drop and our taxes go up, with more of the same expected in 2003. The IRS does give a break to those who are saving for a child's college education through a tax-free savings vehicle known as the IRS Section 529 plan. A 529 plan is a state-run tuition

program that enables families to save for a child's college education while reducing their tax liability. Although many savings-incentive plans limit participation on the basis of the investor's annual earnings, the 529 plan is available to all taxpayers regardless of their income. Advantages to investors include sayings and withdrawals exempt from federal income tax, limited control by the investor over the funds invested, and no restrictions as to the school attended as long as the money is used for higher education.

Most states offer their own 529 plan, managed by a state-chosen investment management company In addition to the advantages that the IRS gives the plans, states can add their own perks, such as state tax deductions on deposits. However, if funds are not withdrawn to pay higher education expenses, the investor must pay capital-gains tax on any interest or dividends earned and a 10 percent penalty on the amount withdrawn that was not used for the above criteria. This situation can be avoided by transferring any unused funds to a 529 plan for siblings.

Additional Benefits

Investors also may realize substantial benefits that are unrelated to saving for college-education costs.

With traditional custodial accounts, such as those set up under the Uniform Gifts to Minors Act, gifts can be made tax-free through use of annual exclusion gifts, which have increased from $10,000 to $11,000 for the 2002 tax year. From an estate-tax standpoint, these irrevocable gifts are removed from the donor's estate. The 529 plan takes it a step farther by allowing a taxpayer to make up to five years worth of excluded gifts in one year, exempt from federal tax for a maximum gift of $55,000 from each donor. Although 529 plans appear to be a great way to remove assets from a grandparent's or parent's estate, if the donor dies during the five-year period, gifts attributed to future years will return to the donor's estate for purposes of calculating the person's estate tax.

Also worth considering is the use of 529 plans as an asset-protection strategy. As 529 accounts grow in value, asset protection will become a higher priority, especially in light of potential judgments that go beyond umbrella insurance coverage limits. The ability of judgment creditors to reach 529 assets varies from state to state. This fact is especially important because donors are not mandated to use the plan offered through their own state. Most states currently allow 529 plans to be set up for nonresidents. Currently, only 11 states (Alaska, Colorado, Kentucky, Louisiana, Maine, Nebraska, Ohio, Pennsylvania, Tennessee, Virginia, and Wisconsin) are governed by statutory language that insulates the plan's assets from the donor's creditors. Restrictions vary, with some states offering limited levels of protection. Whatever the degree of protection, states with statutes restricting access by the donor's creditors obviously offer a greater level of asset protection.

Conclusion

When evaluating and comparing 529 plans, investors should consider all variables that are important to their specific situation. Unfortunately, the information comparing the various state plans that is available in the press and on the Internet tends to focus on state-selected investment managers rather than on estate-tax planning and asset-protection issues. Frequently, investors' objectives go beyond saving for a child's college education. The 529 plans can be structured to accomplish more than one objective, so be sure to plan carefully before investing.

Ronald J. Paprocki, JD, is CEO, MEDIQUS Asset Advisors, Inc., Chicago. His e-mail address is paprocki@mediqus.com.

Joel M. Blau is president, MEDIQUS Asset Advisors, Inc., Chicago. His e-mail address is blau@mediqus.com.

The authors' phone number is (800) 833-8555.