Plan for college with total control

Highlights include large gifts, tax advantages, investment flexibility.

Have you heard of the 529 College Savings Plan? This plan is named after Section 529 of the Internal Revenue Code passed by Congress as tax incentive to save for the ever-increasing cost of educating our children. The 529 College Savings Plan has definite advantages over other available plans. The investment grows tax-deferred and will be drawn out at the tax rate of the beneficiary. It allows for gifting of large amounts of money while maintaining total control of the assets. It allows for estate planning as gifts are removed from the donor estate, and it allows for flexibility of investment choices.

These programs are not easy to understand, and because there are a number of very different programs entering our markets, comparisons are not easy. However, these savings plans are gaining rapidly in popularity because they provide attractive benefits for parents and grandparents who want to invest for higher education. These benefits include total control of the money and the account, no income limits on the benefactor for deductions the way there are with the IRA and Roth IRA and Educational IRA, and beneficiaries can be changed at any time.

How the program works

An individual may gift up to $50,000 or up to $100,000 for a couple per beneficiary. This money is considered a completed gift by the IRS and is removed from the donor’s estate. The donor cannot gift to that specific beneficiary again for five years. What this rule actually does is allow the $10,000 maximum annual gift to be invested up front ($50,000 gifted the first year, then no more gifts for 5 years). At the end of the 5-year period, another $50,000 can be gifted to the same beneficiary.

Should the donor die before the 5-year period is complete, $10,000 for each additional year the donor is not alive moves back to the estate. For example, Doctor Smith gifts $50,000 to a 529 College Savings Plan in year 2001 for his/her grandson. In year 2006 he/she will be able to gift $50,000 again to the same plan for the same grandson. However, in year 2003 Doctor Smith dies. Doctor Smith is allowed to gift $30,000 for years 2001, 2002 and 2003. The additional $20,000 not qualified will be returned to Doctor Smith’s estate. All contributions are allocated on the calendar year, so contributions through December 31 of any given year are gifted in that year.

Donor control

Unlike the Uniform Gift to Minors Account, the donor monitors and has total control of the account throughout his/her lifetime. The Uniform Gift to Minors Account is limited to an annual gift of $10,000. These funds are placed in the name of the minor, and the donor has no control. At age 18 the gift belongs in full to the beneficiary. These funds are taxable.

With the 529 College Savings Plan, Doctor Smith may donate a full $50,000 to a beneficiary and over the next 5 years the full amount will be removed from his/her estate. He/she is in full control of the fund, determines what investments are proper and determines when the beneficiary can receive a distribution and the exact amount of that distribution. Doctor Smith may change the beneficiary at any time to another family member to include himself/herself.

Tax consequences

There are tax consequences in determining the proper beneficiary of this new account. Assuming the beneficiary is Doctor Smith’s grandson, the child will be withdrawing funds from the account as a student. We will assume that as a student the beneficiary is in the lowest federal income tax bracket of 15%. No penalties will apply.

Doctor Smith may decide to use these funds for his/her own benefit or can close the account and move the funds elsewhere. In this case, Doctor Smith will pay a penalty of 10% on the earnings in this account. He/she will also pay federal income tax at his/her own tax rate. This might be considerably more than the student rate.

Limited by states

There are some drawbacks to the 529 plans, and I submit that my clients should invest only a portion of their college savings in such a plan. These plans vary from state to state. Some people might find the investment options too limited. Participants cannot direct their investments as they can in a mutual fund or brokerage account. Once the account holder picks an investment option, it usually cannot be changed. However, some plans allow for new money to be invested differently. The 10% penalty applies to any earnings not spent on qualified education expenses. Money in the account may also impact financial aid for the student.

Not all states offer the 529 College Savings Plan, but many of the plans have been expanded so nonresidents can participate and so money saved can be used at colleges anywhere in the country. Many states have increased the investment options and hired well-known mutual fund companies to manage the money. Some plans now offer state-tax benefits as well as federal-tax benefits.

Choose carefully

Because this is a state-run program, it is imperative the investor does his/her homework and invests through a quality program. Make sure that a reputable company with a long-term track record runs the program you choose and that the investment options work for you.

Some states offer 100% equities, some offer a higher percent of equities for the younger child with more funds moving toward fixed income as the child ages and others offer a guaranteed income option that pays 3% or 4%. Often the option chosen cannot be changed. Fees range from 65 basis points to as much as 110 basis points. (There are 100 basis points in 1%.) The maximum contribution for these college savings plans must be based upon numbers that are reasonable for education per IRS rules. Check the maximum contribution for the plan you choose.

As with any investment, you should check with your financial professional before committing funds to these programs. The 529 College Savings Plan is a fairly new concept, so changes may be forthcoming over the short term.

For Your Information:

• Fred L. Dowd is the owner and agent for Fred L. Dowd Company, a registered investment advisor. He is a portfolio strategist and registered principal through Raymond James Financial Services Inc. member NASD/SIPC. He has physician clients throughout the United States with offices at 104 South Wolcott St., Ste. 740, Casper, WY 82601. He can be reached at (800) 252-3693; fax: (307) 234-3556; e-mail: fldowd@fldowd.com; web site: www.fldowd.com.