States' 529 plans have tax, control advantages

August 1, 2008

With regard to 529 plans, is it advantageous to use my own state's plan, and what are the rules about contributions and withdrawals?

Key Points

Q. With regard to 529 plans, is it advantageous to use my own state’s plan? What are the rules about contributions and withdrawals?

Many states enable investors to take a state income tax deduction for their contributions. In addition, some states make partial matching contributions for residents in certain income tax brackets who contribute to their in-state plan. In many states, the 529 plan is structured as a prepaid tuition vehicle for certain in-state higher education institutions.

Unlike some prepaid tuition plans, 529 college savings accounts can be used to cover qualified expenses, such as tuition, room, board, books, and supplies at almost all public and private institutions of higher education in the United States, including technical and trade schools and junior colleges.

One major non-tax advantage of the 529 plan relates to the issue of control. Unlike the Uniformed Gift to Minors accounts or Uniform Transfer to Minors accounts, in which the minor takes control and ownership of the account once he or she reaches the age of majority, 529 plans allow the account owner to maintain full control of the assets as well as timing of the distributions.

The owner also has the right to change the beneficiary of the account at any time. Doing so creates no tax liability as long as the new beneficiary is a member of the previous beneficiary's family, which, by definition, includes parents, siblings, aunts, uncles, cousins, nieces, and nephews. If you choose not to name a new beneficiary and would prefer to simply liquidate the account by withdrawing the funds unrelated to higher education costs, the earnings portion of the withdrawals will be subject to a 10% federal tax penalty and state and federal income taxes.

In addition, if the plan provided you with state tax deductions, past contributions may be subject to a "recapture," depending on the state, meaning that you may be retroactively taxed on amounts for which you took a deduction.

Unlike IRA accounts, 529 plans do not have income limits based on the taxpayer's earnings. However, 529 plans do limit the amount of the contributions that can be made to avoid gift taxes. For example, a parent or grandparent can contribute the maximum allowable tax-free gift of up to $12,000 annually ($24,000 per married couple) for each beneficiary. A unique provision in the tax law allows the "pre-gifting" of 5 years of contributions by investing up to $60,000 ($120,000 per couple) per beneficiary in a single year. But keep in mind that no other gifts can then be made for the following 4 years.

Since the introduction of 529 plans in 1996, their relative simplicity, flexibility, tax benefits, and high contribution limits have made these college savings plans very popular, but it is important to fully understand the differences among the states that offer them.

If your state or your designated beneficiary's state offers a 529 plan, you may want to consider what, if any, potential state income tax or other benefits it offers before investing.

Please contact your financial consultant to obtain a Plan Disclosure Document or prospectus for any of the underlying funds. It contains complete details on investment objectives, risks, fees, charges and expenses, as well as more information about municipal fund securities and the underlying investment companies that should be considered before investing. Please read the Document carefully prior to investing.