529 Plans: A Great Idea, But Know the Rules

May 25, 2011

Dear Carrie, 

I have several questions about 529 plans: I live in New York, and my grandchildren live in California. Does it matter what state I open the account in? Does my contribution affect my taxes in any way? The fine print says the money can only be used for "qualified educational expenses" at an "eligible post-secondary institution." What does this mean? And finally, what happens if one of my grandkids doesn't go to college?

—A Reader

Dear Reader,

You are doing a wonderful thing for your grandchildren by opening 529 plans on their behalf, and I applaud your generosity—as well as your good questions. It's always a great idea to understand the proverbial "fine print" when it comes to financial matters, so let's get to it:

What state's plan should you choose? You can contribute to a 529 plan sponsored by any state, and the money can be used by the beneficiary at any accredited college, university, or vocational school, regardless of where you or your grandchildren live. Currently 34 states offer a state tax deduction for 529 contributions for residents; New York does, but California does not. A state tax deduction can be an inducement, but for most people, it's probably more important to choose a plan that offers good investment choices and charges low fees. And for your convenience, many financial institutions offer 529 plans. Bottom line: Compare plans before you invest!

What are the tax consequences of a 529 gift? Even though some states do offer an income tax deduction for 529 contributions, there's no federal tax deduction. You should also know that you can make substantial contributions without triggering gift taxes: up to $65,000 ($130,000 for couples sharing gifts) within a five-year period. And, as I'm sure you know, investments in a 529 plan grow tax-deferred, and withdrawals are tax-free as long as they're used for "qualified educational expenses." This brings me to your next question.

What are qualified educational expenses? For full-time students and part-time students attending at least half time, qualified educational expenses are pretty much what you'd expect: tuition, fees, books, supplies, and required equipment (including a computer, if required by the school), as well as room and board. If a student is attending less than half-time, room and board don't qualify. Plan assets cannot be used for travel, extracurricular activities, or spending money, but those expenses are generally dwarfed by the big ticket items like tuition and room and board. (Be sure to note, though, that if you do use the funds for non-qualified expenses, the earnings are subject to both ordinary income taxes as well as a 10 percent penalty.)

What is an eligible post-secondary institution? Any accredited college or university, including public, private, and for-profit schools, along with accredited vocational or other formal career training programs, can be paid for with withdrawals from 529 plans. Ask the school to ensure it is accredited, but most are. (For more information, check out the Department of Education website at education.gov.)

What happens if a plan beneficiary doesn't go to college? 529 plans are surprisingly flexible on this front: The law permits you to transfer unused funds to virtually any family member, including you, your spouse, any child, grandchild, or great-grandchild (and his or her spouse), your parents, nieces and nephews, in-laws, and first cousins. In other words, you should have no trouble finding some relative who can put that money to work!

If you are concerned that one of your grandkids might not go to college (and you don't have another potential beneficiary), you could put all of the assets into a single account for the older child; if he or she doesn't go to college or some other post-secondary school, transfer the plan assets to the younger child. And if you're really, really worried that neither might go to college and there's no one else to transfer the 529 assets to—a very unlikely scenario—then you could simply invest the money in a traditional brokerage account and be prepared to help out your grandchildren financially if the need arises.

I want to point out that by helping your grandchildren you're also helping your own children. They've got financial challenges as well, from saving for or paying for a home to building wealth for their own retirement; college is yet another burden, and often a huge one, for them to bear. Clearly, your gesture is generous on many levels, and will be appreciated by your kids and their kids. Thanks for the questions!

Important Disclosures

Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. This information and more about the plans should be read carefully before investing.

As with any investment, it's possible to lose money by investing in a 529 plan. Additionally, by investing in a 529 plan outside of your state, you may lose tax benefits offered by your own state's plan.

Before making beneficiary changes to a 529 plan, please consult a tax professional.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction and investment strategy for his or her own particular situation. Data contained here is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.



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