The 529 Savings Plan

Many parents wish they would or could have saved for their son or daughter’s college education. Over the past six years, there have been different federal initiatives to spark educational savings, from the Hope Scholarship and Lifetime Learning tax credits to the latest college savings rage, the 529 college savings plans named after a section of the tax code.

With the 529 college savings plan, you can save for anyone—your child, your grandchild, a niece or nephew, a friend or even yourself! You can also change the beneficiary to another member of the beneficiary’s family. While contributions are not deductible for federal tax purposes, through 2010, earnings and withdrawals used for qualified higher education expenses are tax-free! (Higher education expenses include tuition, room, board, required books and supplies.) However, if you participate in your own state’s plan, you are able to deduct the contributions on your state income tax return.

The 529 college savings plans offer higher contribution limits than the second most popular federal option, the Coverdell Education Savings Account (ESA). People of all income levels can open a 529 savings account.

Each state sets the contribution limits for its plans, so if you plan to save more than the Coverdell ESA annual limit of $2,000, the 529 plan is an excellent option. Please note you can contribute to both an ESA and a 529 program for the same individual in the same year.

The assets in a 529 plan are considered the property of the person(s) who opened the account, typically the parents and/or grandparents of the student. Because assets and savings in the student’s name have a bigger impact on financial aid than what’s in the parent’s name, the 529 plans are financial-aid friendly.

With every financial plan, you should consider the drawbacks before finalizing your investments. Federal law requires that 529 assets be professionally managed; you can’t choose individual stocks, bonds or other investments in a 529 account. You must choose from several mutual fund-type plans offered within your state’s 529 plan. Also, there are annual limits to how often you can change your investment choices.

If you withdraw money for something other than qualified higher education expenses, you will owe federal income tax and may face a 10 percent federal tax penalty on earnings.

Remember, under current tax law, the ability to withdraw money from a 529 plan free from federal tax ends in 2010, but this may be extended. Whether distributions from a 529 plan will be free from state taxation depends on your contributions and perhaps whether your assets are in another state’s plan.

Some states offer residents an incentive to invest in their state-sponsored 529 college savings plans. Be sure to ask your tax adviser how a contribution to your state’s sponsored 529 plan will affect your state tax bill.

As college savings plans go, the 529 plans are a valuable asset for anyone who wants to save for higher education.

Rick Ross is director of client relations for M&T Bank Educational Lending. You can reach him at [email protected].

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