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Section 529 Plans-The Fine Print

State sponsored college savings plans, named “529 plans” after the implementing tax law section, are all the rage these days in the financial press and investment firms’ advertising literature. With both of my sons heading to college within the next 1-1/2 years (hopefully), I have a personal interest in reducing the sticker shock I am experiencing on our college visitation trips.

Being a skeptic, I began to wonder whether there might be some downsides under the avalanche of 529 hype. So, this month, I peak under the hood to point out some oft overlooked considerations.

The public coverage extols three clear benefits – gift tax savings, income tax savings and control. But, there are some trade-offs for each. Plus, there are alternatives to achieve similar benefits.

Gift Tax Savings

You can put up to $55,000 ($110,000 if you are married) into a plan for each of your children and grandchildren with no gift or generation skipping tax. Five years later, you can make an additional contribution unless the plan balance exceeds its cap (typically set by the plan administrator somewhere between $200,000 and $300,000). The fund can be used to pay “qualified educational expenses” (tuition, fees, books, room and board) for the beneficiary.

However, contributions to 529 plans use your annual gift tax exclusions. That may be a waste. Without the 529 plan, you could pay tuition directly and make annual exclusion gifts, all without gift or generation skipping taxes. This wastage may be particularly important for family business owners and wealthier people who often use their annual exclusions to transfer business or family limited partnership interests at discounted values. It also can create an unpleasant surprise for those who forget that they committed their annual exclusions to fund life insurance trusts.

Income Tax Savings

Income and capital gains earned within the plan are never taxed as long as the plan assets are used to pay qualified education expenses. You might also get a state income tax deduction for all or part of your contribution to a plan sanctioned by your state. (Or you could move to Texas and not worry about state income taxes at all!)

The income tax benefit is real, although you risk taxes and a 10% penalty on earnings distributed for nonqualifying purposes. I discounted this benefit somewhat in my case because of my sons’ ages. The money will be used rather quickly, so the earnings and resulting tax savings may be rather modest. If your kids or grandkids are younger, the potential income tax benefit increases.

As an alternative to a 529 plan, I could give the money directly to my kids and any earnings would be taxed to them at their zero or low income tax rates. If I fear they might squander the dough, I could use a trust and distribute only the income to them each year to use their low brackets. However, if your kids or grandkids are under 14, the “Kiddie Tax” will tax the income at the parents’ higher brackets. Consider a combination of municipal bonds and index-based or other tax efficient forms of stock market investment.

Retained Control

A 529 plan allows you to retain the ability to change the beneficiary to another family member. Typically, the estate and gift tax rules won’t allow you to retain that type of control over gifted funds. It also is unique because you could withdraw the funds for yourself, although you will pay tax and a 10% penalty on the accumulated income.

There are alternatives to retain control of gifts outside of 529 plans. For example, as general partner of a family limited partnership, you can retain significant control over distributions, although any distributions must be proportionate to all partners. Add a trust with a friendly trustee, and you can further fine-tune distributions on a kid-by-kid basis.

Obvious Gotchas

There is a reason why the financial services industry pushes these plans. The fees can be extraordinarily high. Check the fine print closely for enrollment fees, load and early withdrawal charges, plus annual account maintenance fees, asset-based management fees and fund operating expenses. A maximum tax savings of up to 20% on gains and 40% on income may not outweigh high expense charges on total assets, especially with today’s meager investment returns.

Most plans severely limit investment options (e.g., two to five choices as to the percentages of the fund invested in stocks versus bonds and money market funds) and only one investment manager. Sophisticated investors know that portfolio allocation and manager selection are key considerations in an investment plan, yet you have no control beyond the plan’s narrow constraints. Also, you may change investments no more often than annually.

Rarely in Print

There are some other possible surprises, including:

  • If the donor dies within five years of funding a 529 plan, a portion of the contribution will be brought back into the taxable estate and might also be subject to generation skipping tax consequences.
  • There are gift tax consequences if you change the beneficiary to someone in a generation younger than the original beneficiary or to someone who is not a member of the same family.
  • Suppose you created a plan in your state and enjoyed a state income tax deduction. If you later decide to move the plan to another state to reduce fees or take advantage of better investment management, your state may require you to recapture your prior deduction. Conversely, while your state may not tax withdrawals from its sponsored plan, it might tax withdrawals from other states’ plans.
  • In these days of federal and state budget shortfalls, one wonders about the future taxation of these plans given their popularity. Section 529 expires at the end of 2010. Absent Congressional action, income withdrawn after 2010 will be subject to income taxation. Although it is unlikely that Congress would allow the provision to expire in its entirety, the search for revenues could lead to restrictions. Similarly, the states may decide to alter their taxation rules.

The choices are rather mind boggling, although the actual creation and operation of a plan is very simple. There are a number of excellent resources to help you understand the rules. One of the best is, which has a handy tool for comparing the various states’ plans.

Marketers claim that 529 plans are the best thing since sliced bread. Depending upon your situation and needs, they might be right. However, look past the hype to avoid becoming toast.

Ross W. Nager is senior managing director and principal, Sentinel Trust Company, Houston, TX.




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