529 plans not always best option

By: Savingforcollege.com


Dear Joe, In about one month, my wife and I are expecting our first child. We have already begun saving for the child's education, but we have been doing it through mutual funds. The sole purpose of the funds is for our children's education. In retrospect, I wish we had opened a 529 plan. I realize we can't roll over mutual funds into 529 plans, but should we cash in our mutual funds (we have about $50,000 total in nine different funds) and open a 529 and a Roth? Should we leave the money alone? Or should we do something in between? -- Matt


Dear Matt,

Before getting to your specific question, let's be sure you are taking care of more important and pressing issues before your first child arrives.

Do you each have a will? Have you named a guardian in case something happens to you both? How about life insurance -- do you have enough? If your answer to any of these questions is "no," pay attention to those needs first.

Now let's talk about the education savings. The income tax bite on your mutual funds can have a significant negative impact on investment returns over time. The Roth IRA and 529 plans offer the advantage of tax-deferred earnings as well as tax-free qualified distributions down the road.

If you don't have a lot of untaxed appreciation in the mutual funds, this might be a good time to liquidate at least some of those funds, set aside enough of the proceeds to pay the capital gains tax, and reinvest the balance in a Roth IRA or 529 plan.

If the appreciation in your funds is more significant, take a close look at the impact of the capital gains on your overall tax situation. You may want to spread the gains out over two or three years. Note that capital gains tax rates are currently scheduled to increase in 2011.

In choosing between the Roth IRA and 529 plan, most financial planners agree that retirement should take higher priority and that you should fund the Roth before contributing to a 529 plan.

With a Roth IRA, you can pull out contributions at any time for any reason without tax or penalty and leave the earnings in the account for tax-free withdrawal after age 59½. A Roth IRA also offers a wide selection of mutual funds and self-directed investments.

Meanwhile, there are fewer investment options in a 529 plan, although these choices are more than adequate for the majority of American families. The ability to change investments is also more restricted in a 529 plan.

Also, consider whether your state offers a state income tax deduction or credit for your contributions to its 529 plan. A small number of states, including Kansas, Pennsylvania and Maine, permit a deduction for contributions to any state's 529 plan. You will not receive a state tax deduction for contributions to a Roth IRA.

If you don't mind the prospect of your child having control of the money at age 18 or 21, consider gifting some of your mutual funds to your new child before selling them. You can do this by establishing a Uniform Transfers to Minors Act, or UTMA, account.

In 2007, the first $850 of gains recognized by your child will be free from federal taxation and the next $850 will be taxed at a 5 percent capital gains rate. Above $1,700 in unearned income, the so-called kiddie tax -- which prevents parents from taking advantage of their child's lower tax rate -- kicks in.

In 2008, the caps change slightly and the 5 percent capital gains bracket becomes a zero percent bracket, meaning your child can recognize up to $1,800 in capital gains in 2008 before any money is subject to federal taxes.

Money in the UTMA account could be invested in a 529 plan to avoid taxes, including the kiddie tax, in the future. Your child will not be able to open a Roth IRA because contributions are limited to earned income.

As a final note, consider the gift-tax impact of any moves you make. Gifts into a UTMA are subject to your $12,000 gift-tax annual exclusion. So are contributions to a 529 plan for your child, although the five-year election allows you to spread contributions above $12,000 over five years to help stay within the $12,000 annual exclusion

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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