Maintain 529 plan savings in college years

http://www.savingforcollege.com/articles/20090619-maintain-529-plan-savings-in-college-years

College expenses are increasing rapidly — faster than inflation in recent years. Private four-year college tuition increased by 5.9 percent for the 2008-'09 school year and 6.4 percent at public four-year colleges. The U.S. Department of Education's National Center for Education Statistics says only 40 percent of all students graduate in four years. An extra semester or year can add anywhere from 10 percent to 25 percent to the overall bill.

In addition, after college, hundreds of thousands of students enroll in graduate school, law school, medical school or other postgraduate education. Graduate school tuition of any type is generally more expensive than undergraduate tuition.

There are plenty of reasons to continue adding to your 529 plan: Many states offer generous tax deductions or credits; contributions grow free of federal tax; you can get ahead on future tuition bills for college or graduate school; and you have the opportunity to impose budgeting discipline on your financial situation. The disadvantages include potential investment losses and fees, as well as the spending limits imposed on 529 plans.

"If you're still setting aside money to pay for college, it makes sense to keep using a 529 plan," says Joseph Hurley, a certified public accountant and founder of Savingforcollege.com. "It's a way to get tax-free funding. Since most parents want to invest more conservatively for older children, you are generally talking about investing in money markets, fixed income and the like."

Tax advantages

Contributions to 529 plans offer federal and, in many cases, state tax advantages. As far as federal taxes go, you can use your contributions to pay for college without paying taxes on gains on dividends, interest and capital gains on your original 529 investments. Many states offer tax deductions to residents contributing funds to an account. These advantages hold true regardless of when you contribute or withdraw contributions.

By running your contributions through a state plan that offers a deduction to in-state residents, you reap an immediate benefit, even if you withdraw those funds shortly afterward to pay qualified tuition expenses. State income tax deductions vary — none in some states and full deductibility in others. The value of a tax deduction varies on the size of the deduction, your income and the tax rate.

Several states — including Vermont, Missouri and Indiana — offer more valuable tax credits. Tax credits are more valuable than tax deductions because they reduce your taxes dollar-for-dollar rather than by a percentage based on your tax rate. To find out if your state provides a tax deduction or credit or offers reciprocity for deductions made in other states, select your state on our map. You can find a summary of deductions and credits in various states at FinAid.org.

Whether your state offers a credit or a deduction, taking advantage of it is a compelling reason to continue to contribute to a 529 plan when your child is in college, says Ken Bower, a Certified Financial Planner with Moneta Group, a wealth management firm in St. Louis. "In Missouri, for example, you get a 6 percent credit. So if you contribute $100, the state is literally giving you free money of $6 off your next state tax return."

Some states offer tax parity, through which contributions to any state plan receive a state tax deduction. To date, these states include Pennsylvania, Arizona, Minnesota, Montana, Missouri and Kansas. If you live in one of these states, you can deduct your contributions, subject to any state restrictions, even if you have a plan in another state.

Be aware that some states restrict your ability to immediately withdraw funds by imposing withdrawal limits of anywhere from 10 days to a year. However, most states don't impose such restrictions, says Hurley. "Most states are not aware enough that this is happening to restrict it. They have no clue," he says.

Budgeting advantages

There are two ways to handle contributions made during the college years. You can remove the funds as soon as possible to pay current tuition, room, board, fees or other expenses, or you can use the funds to pay expenses for future years or graduate school.

In the first instance, you aren't putting any extra money into your 529 plan. Rather, you are taking money that you would have spent anyway out of your income on college-related expenses, placing it in the 529 plan for a short period, and then removing it to pay current bills. Because these contributions are so short-term, you likely wouldn't gain anything much from the federal tax benefit that provides tax-free withdrawals from 529 plans. The contributions won't be in the plan long enough to generate interest, dividends or capital gains.

On other hand, the state tax deduction or credit will apply, if your state has one. So it can make sense to run your contributions through the 529 plan to gain this benefit on this year's state tax return. Before using this strategy, check your state plan documents for any withdrawal limits or tax deduction limits that would disallow deductions or credits.

If your plans don't involve quick withdrawals to pay this year's bills but rather contributions to cover future years, you may benefit from federal and state tax law because your contributions may be invested in plan assets long enough to generate federal tax benefits as well as a state tax deduction or credit. Even a small monthly contribution such as $50 or $100 can make life easier in the future in the form of smaller bills for tuition, room and board.

Disadvantages

There are several disadvantages in contributing to a 529 plan while your child is in college.

"The big downside of having a 529 plan and putting money into it at a late date is there are going to be fees attached to it," says Susan Howe, a certified public accountant with Ernst & Young and a member of the American Institute of Certified Public Accountants' National CPA Financial Literacy Commission. "Why not gift the money to the college student through a nontaxable gift and maintain your flexibility, instead of incurring fees you could avoid." Potential 529 plan fees include those to open an account, recurring management fees and annual account fees.

Another disadvantage is the potential for investment losses, if, for example, the plan invests in an aggressive option that uses stock mutual funds. In any market, losses can happen too quickly for you to react by changing to a different investment option. In any case, 529 plans restrict you to one investment change per year, though Congress has relaxed this restriction just for this year to allow two investment changes.

A way to avoid this problem is to choose a conservative investing option such as a money market account, bank-insured savings account or a stable value fund, as such funds are unlikely to lose money in the short term. Of course, they are not likely to generate much in the way of investment returns, either.

Because 529 plan funds are restricted to qualified expenses at qualified higher education institutions, you may have to pay penalties or tax on funds you remove from these accounts and use for other purposes. You won't have to pay federal tax on your contributions because all 529 contributions are on an aftertax basis as far as federal taxes go.

If you have positive returns on your 529 plan contributions and withdraw them for a nonqualified purpose, you'll have to pay a 10 percent penalty on any earnings, and those earnings will be taxed as ordinary income. If you received a state tax deduction or credit, you'll have to pay tax on those amounts.

Posted June 17, 2009