Section 529 Plans
By Larry Zagarola, CPA

How would you like to save for your child's or grandchild's higher education costs and have the income earned on these savings grow tax-free? In addition, the withdrawals from these savings will be tax-free, you will have complete control over the use of these funds, and you keep their value out of your estate and never pay gift or estate taxes on them. Sounds too good to be true? It was - until the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("2001 Tax Relief Act").

In the Summer 2001 issue of the Quarterly Review, Neil Becourtney introduced us to changes in the tax law concerning qualified tuition programs, commonly referred to as Section 529 Plans. As a result of these enhancements, taxpayers may save using a unique combination of estate and education funding planning. We have all read the frightening projections on what it will cost to send a student to college over a four-year period. The trend clearly shows the need for careful planning in order to maximize a family's ability to meet their needs in the future.

The liberalization of the tax treatment on withdrawals from 529 Plans, combined with favorable estate, gift and income tax provisions, provide parents and grandparents with excellent opportunities to accomplish multiple goals, when properly planned. Some of these opportunities are listed below.

Education Savings Planning
Before discussing the savings aspects of these plans, there are three items to point out:

1. We are discussing 529 Savings Plans, not 529 Prepaid College Tuition Plans, which have a different set of rules that govern their effective use.
2. There is no income limitation set by Congress. The parent or grandparent can have any level of income ($0 to infinity) and still contribute to the plan. There is, however, a maximum contribution amount that is established by each State.
3. 529 Plan withdrawals can be used to pay for any higher education endeavor in an accredited program. If the student wants to become a chef or an auto mechanic, and there is an accredited program, the funds can be used.

The cost to educate a child who is five years old in 2002 in a private university is projected to be $210,000 over a four-year period. This includes tuition, books, room and board. With the tax free withdrawal provisions, if the maximum ($110,000) was contributed to the 529 Plan by either the parents or grandparents in 2002, and the savings plan grows at 6% compounded until the student starts school, there would be a sufficient amount ($234,000) set aside for education without any taxation of the accumulation to the funding parents or grandparents.

Estate and Gift Tax Planning
Estate and gift tax planning not only includes the eventual savings of taxes, but may also include objectives related to the use of the assets by the beneficiaries. In most situations, you cannot retain control over beneficiary use and escape the taxes. However, investments in 529 Plans enable you to do just that. Special rules permit taxpayers to use five years of gift tax free transfers in one year, ($55,000 starting in 2002) for each beneficiary ($110,000 for a married couple). The amount is then permanently removed from the estate at a rate of one-fifth per year. The taxpayer, however, retains control over the assets in that they can change the beneficiary, use excess funds to benefit other beneficiaries and even take the funds back by paying the tax and a penalty. Transferring assets by using this planning tool enables the parents and/or grandparents to make sure the funds are used for the purpose intended - higher education - which is not something that other gifts can accomplish.

Potential Concerns
There are three areas of concern one must take into consideration when deciding on using 529 Plans to help fund a child's higher education. One such concern is the lack of control over how the money is invested in the state sponsored programs and another concern is over the effect the current December 31, 2010 sunset provision has (although it is anticipated that these provisions will be renewed) on the withdrawal of funds. However, the most significant concern is the effect 529 Plan assets have on the ability of the beneficiary to receive financial aid. The financial aid formula is complex. In addition to the U.S. Department of Education's definition of financial aid, many private institutions have their own rules and, therefore, we will not try to explain the total aid formula. We will address one significant point. There are different ownership options available to the person establishing the 529 Plan, and each option has a different effect on the financial aid formula. If, for example, the child is the owner, as is the case in gifts made under the Uniform Gift to Minors provisions, the Federal formula assumes 35% of the child's assets are available for education. If the parents are the owners, then only 6% is used, and if the grandparents own it, nothing is used.

Despite these concerns, Section 529 Plans offer enormous financial and education planning opportunities that should be carefully examined. If you would like more information on Section 529 Plans, please contact Larry Zagarola, Managing Director, Cohn Wealth Management, at (973) 364-0001 or via email at lzagarola@cohnwm.com.