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So Says the 529 Guru

No. 3
Joe Hurley
Thursday, October 31st 2002

Hi everyone! The first question below demonstrates why you might want to order a copy of our 2002 Year End Planning for Education Tax Benefits. Be sure to get all the tax savings available to you.

Question: I read in a recent magazine editorial that using 529 funds may make you ineligible for the Hope and Lifetime Learning credits. Could you discuss why that is? - K.C.

Answer: K.C., you've touched upon the most worrisome aspect of the new education tax breaks: their complexity. It's wonderful that Congress has created so many special incentives to help families afford college and graduate school costs, but now you have to deal with an intricate web of rules that can frustrate even the most experienced tax professional. When preparing your taxes, you will be forced to apply a certain priority so that the same dollar of education expense cannot be used to provide multiple tax savings. In other words, no double-dipping.

529 plans and the Hope and Lifetime Learning credits are a perfect example of this, although it doesn't work exactly as you suggest. You must first figure your Hope or Lifetime Learning credit on qualifying tuition and fees, Then you use any leftover tuition and fees, along with other qualifying college expenses such as books, supplies, and room and board, when computing the portion of your 529 account withdrawals that come out tax-free.

Is this reason to stay away from 529 plans? Hardly. An example will demonstrate:

Mom originally put $6,000 into a 529 plan for her daughter Sue and the account grows to $10,000 by the time Mom uses it to pay for Sue's first year of college. Mom expects the $4,000 in gains to come out tax-free because the money is used to pay for Sue's $10,000 in qualified higher education expenses ($4,500 of which is tuition).

When preparing her taxes, Mom finds that she can claim a Hope credit of $1,500, which is 100% of the first $1,000 of Sue's tuition and 50% of the next $1,000. Because she has "used up" $2,000 of tuition in claiming the Hope credit, only $8,000 of qualified expenses is left for the $10,000 withdrawal from the 529 plan. This means that $2,000 of the withdrawal is "nonqualified" and that one-fifth of the $4,000 in gains, or $800, is taxable as ordinary income to Sue.

If Sue is in the 15% federal tax bracket, she pays $120 in tax on the 529 withdrawal. But Mom has earned a $1,500 tax credit. It's obvious that they are still much better off. (If Sue had incurred at least $12,000 in qualifying 529 expenses, rather than $10,000, the family would have had the full benefit of both tax breaks.)

Want more complications? You'll find them if Sue receives any scholarships; or if she takes withdrawals from a Coverdell education savings account in the same year; or if Mom takes early distributions from her IRA; or if Mom redeems certain qualifying Series EE United States savings bonds. Special coordination rules apply in all these instances. Get the Excedrin ready.

Question: What are some of the things to watch if you rollover a prepaid plan to a college savings plan? - RD

Answer: Now why would you want to go and do that, RD? At many public colleges and universities, the tuition and fees are skyrocketing. Just this month the College Board came out with its annual report showing tuition and fees at the average 4-year public institutions to be 9.6% above last year's average prices, representing the largest jump since 1991. That figure is even more impressive when you consider that the general inflation rate was only 1.5%.

Most of the 17 state-run prepaid tuition plans are designed to protect families from this type of unpleasant surprise by footing the beneficiary's tuition bill at any in-state public institution no matter how high it is. Families with children enrolled in these programs are probably feeling pretty good about their investment right now. (If you are considering joining your state's prepaid program—assuming you live in a state that offers one—be sure to consider how the price of the tuition protection compares to current tuition levels. Some states have started charging a significant premium.)

Stock market woes have caused many accounts in 529 college savings plans to sink in value. But there may still be good reason for the owner of a prepaid tuition contract to consider transferring his or her investment to a college savings plan. For example:

- You expect a moderation of future increases in tuition and fees at public institutions in your state. After all, college costs can't keep going up by five times the rate of inflation forever.
- You expect investment returns in the college savings plans to improve in the future. After all, the stock market has to start going up again sometime.
- Some combination of the above.
- Your child is heading to a private college or out-of-state college and the prepaid tuition contract you hold doesn't convert at full value. (Check with your state, as it may not pose this problem.)
- You are afraid your prepaid tuition plan may sink under the weight of the tuition increases, and unless the state is legally obligated to back up the program's promises, your benefits could be reduced if the program becomes insolvent.
- You want to improve your child's eligibility for federal financial aid. Prepaid tuition plans reduce financial "need" on a dollar for dollar basis. Switching the money to a college savings plan, where only a fraction of the value is counted in determining eligibility, could produce a much better financial aid package.

The biggest potential drawback of switching from a 529 prepaid tuition plan to a savings plan is that your prepaid tuition plan may treat your decision to pull the money out of the plan and into another state's 529 savings plan as a "cancellation" of the contract. The fact that the move qualifies as a tax-free rollover for federal income tax purposes will provide little consolation. Cancellations are often subject to severe financial penalties, in some cases returning your original payments reduced by an administrative fee, and without any interest. If you were able to claim a state tax deduction for your payments into the plan, you may be required to pay state recapture tax.

Luckily, every state with a prepaid tuition plan now has a college savings plan too (or will have one soon). Most of these states provide a much better answer when the rollover is going from their prepaid plan into their own college savings plan. Be sure to consider this possibility before attempting to transfer your prepaid investment to another state's 529 plan.

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