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COLLEGE SAVINGS 101

Keep paying 529, even with kid in college

01/04/2010

QUESTION:
Dear Joe,

We have three children. We have a 529 for each one of them in an age-based option. One is college bound this fall. Should I continue to make contributions to his 529 when he is enrolled in college? All of our contributions come from after-tax funds. I am in the 30-plus percent tax bracket.

--Jeff

ANSWER:
Dear Jeff,
As long as you have the financial means, it probably makes sense to continue your contributions to his 529 plan. I'm assuming, of course, that you currently do not have enough money in your oldest child's 529 account to fully pay his college education, and that you (or he) will eventually have to come up with more.

Even when the period before withdrawing the funds is brief, placing your college savings into a 529 plan means you'll pay less income tax, thus leaving more in your account to pay school bills. If you were to park the money in a taxable bank CD or money market fund instead, you would be sending a large portion of the interest you earn -- 30-plus percent, based on your tax bracket -- to the government. Tax-free income from a 529 plan also is excluded on the federal financial-aid application, or FAFSA.

And here's a special reason to keep contributing: Residents in 34 states and the District of Columbia can claim a state tax deduction or tax credit for their contributions to a 529 plan. Most of these states impose no waiting periods, and so you can pick up a generous guaranteed return even for a student already in college. Check the eligibility rules in your state.

If you continue your contributions into your oldest child's 529 account and it turns out the account has more money than needed to pay his expenses, you can change beneficiaries to one of your younger children. Or you can simply transfer funds into their existing 529 accounts. Moving the money among family members is tax-free.

You can also move 529 funds in the opposite direction, transferring from a younger sibling to the current college student whenever more money is needed to pay for college. While this possibility may suggest that you direct all your contributions to your younger children, remember that the age-based portfolios being used for your younger children may not be appropriate for the child who is about to enter college.

Gift taxes should also be taken into consideration. You and your spouse can apply as much as $26,000 in gift-tax exclusions for your contributions to each child's 529 account. Even larger contributions may be possible with a special five-year election. Naturally, you have more gift-tax allowance when contributing for all three children. Moving the money later between accounts does not trigger gift taxes when the beneficiaries are of the same generation.

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