Tax Deferment for College Savings

By Phillip L. Pennartz, Entrepreneur.com

I've heard about 529 college savings plans. What exactly are they, and how do I go about evaluating them for my situation?

Section 529 Plans became a part of the Internal Revenue Code in 1996, when Congress initiated tax incentives to encourage families to save for college. Until this year, earnings in a 529 plan would grow tax-deferred until you made qualified withdrawals. Then you would pay federal income tax on the growth at the beneficiary's rate (usually 15 percent).

But now, due to the Tax Relief Act of 2001 (put into effect January 2002), 529 Plans are even more attractive for college savers, in terms of both tax and estate-planning benefits, including:

• Tax-free earnings: Starting this year, your investment in a 529 Plan grows federal income tax free.
• Tax-free withdrawals: Whereas you used to have to pay taxes on growth for qualified withdrawals, now distributions for qualified education expenses are federal income tax free. Qualified expenses include tuition, room and board, books, supplies and equipment.
• No income limitations: Unlike the Coverdell IRA, which excludes people with incomes exceeding $220,000, 529 Plans are open to everyone, regardless of income.
• Donor-controlled disbursements: If plans change and your child earns a full scholarship or decides not to go to college, you can designate another relative as the beneficiary. With the UTMA (Uniform Transfer to Minor Act), for example, you relinquish control over the account once the child reaches legal age, which is 18 in most states. If the beneficiary would rather use the funds to buy a Harley instead of attend Harvard, you have no recourse. The 529 Plan protects against potential misuse by giving you, the donor, control over the funds.
• Estate planning benefits: When contributing to a 529 Plan, you get the best of both worlds from an estate planning perspective: You can move significant assets out of your estate and retain control of disbursements. You may also reduce your taxable estate by $55,000 (or $110,000 for married couples) per beneficiary in the first year, without gift tax consequences. The IRS treats the $55,000 as if it's paid in on a prorated scale at $11,000 per year over a five-year period.
• High maximum contribution limits: The maximum contribution varies from state to state, with the current cap at $265,000. One investor can contribute more than that limit by opening multiple accounts for different beneficiaries.