Monthly top tips

So Says the 529 Guru

No. 19
Joe Hurley
Friday, May 27th 2005

Question: I have looked on your FAQ on the web site and could not find the answer to the following question: Are 529 plans applicable for U.S. students looking to study in Canadian universities?

Answer: Actually, you can find the answer on our 529 FAQ page, but it may not be obvious and I am happy to elaborate here. The definition of "eligible institution" for 529 purposes includes many foreign institutions, in Canada and elsewhere around the world. In order to be included, the foreign institution must be eligible to apply to participate in the Federal Family Education Loan (FFEL) programs administered by the U.S. Department of Education. The financial aid regulations state that the Secretary of the Department of Education must approve the foreign institution in order for it to be eligible.

Approved institutions are assigned a "school code" by the Department of Education to be used by students when applying for financial aid programs. You can look up a particular institution on a page we have set up (click HERE ) using the Department of Education's school code list. If searching by state, select "Canada" in the state dropdown box to locate eligible institutions in Canada (select "Foreign Country" for most other international schools).

I am often asked a related question: If a school in the United States may be eligible for federal financial aid programs, but for whatever reason chooses not to participate, can it still qualify under Section 529? The tax regulations are not entirely clear on this question. My suggestion is for 529 plan participants to rely on the Department of Education's school code list and to assume that if a school does not have a code then it is not eligible for 529 treatment. Even if a particular school believes it would be approved by the Department of Education, it cannot be certain until it has actually made application.

Question: I live in Florida and I'm going the prepaid way. I'd rather have peace of mind that my two-year old twin daughters' college is paid for as opposed to a 529. I want to pay for the prepaid plan in one lump sum. Would I be better off paying for it by cashing out my EE savings bonds, taking a HELOC (5.75%), or taking out a loan on my 401(k) (4.5%)?

Answer: First, allow me to clear up a common misconception. State-run prepaid tuition plans (with the apparent exception of the Massachusetts U.Plan) are 529 plans too. The private-college Independent 529 Plan is also a 529. All 529 plans, whether prepaid or savings, are subject to the same federal income tax and gift/estate tax treatment. Unfortunately, prepaid plans are currently at a disadvantage when it comes to applying for federal financial aid but the odds are good that the disparity will disappear with a bill now working its way through Congress.

Florida's is the largest, and one of the oldest, prepaid plans in the country. Several states, facing fund deficits cause by investment returns lagging behind tuition increases, have stopped taking new enrollments into their prepaid plans. Florida's program and a few other state-run prepaid programs still seem to be going strong. Independent 529 Plan doesn't face the same kind of risk as state-run plans because tuition increases are absorbed by the participating colleges.

It's not possible for me to suggest the best way to fund your daughters' prepaid tuition plans without knowing more about your personal situation. Your investment return from a prepaid tuition plan will equal the value of the tuition benefit in their college years less the amount you pay into the plan. (I'm assuming here that Congress will make the 529 exclusion permanent so that you don't have to pay income tax on the earnings.)

Series EE and I savings bonds can be a tax-free investment for your dependent's college tuition, as long as certain conditions are satisfied. In fact, you don’t have to wait for college if you redeem the bonds in an earlier year when redemption proceeds are rolled into a 529 plan for yourself, your spouse, or your dependent. To qualify for the interest exclusion, the bonds must be post-1989 bonds issued in your name no earlier than the month you turned age 24, and your income must be below a certain level in the year of redemption. For 2005, the exclusion is phased out for incomes between $61,200 and $76,200 (between $91,850 and $121,850 for married taxpayers filing jointly). In testing your income, be sure to include the interest on redeemed bonds, whether excludable or not.

Borrowing against your home (HELOC) or against your 401(k) retirement account is a leveraging strategy that can make sense if you believe the return on your tuition prepayment contract will exceed the after-tax interest on the loan. Interest on up to $100,000 of qualifying home-equity indebtedness is deductible on your income tax return, but may not provide a benefit if you are subject to the alternative minimum tax. The interest on a 401(k) loan used to purchase tuition is probably not going to be deductible on your income taxes. Remember, the loan will have to be paid back over time, while your investment presumably stays in the 529 plan until the college years.

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