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Sec. 529 Planning with college savings plans. (FinancialPlanning).

The 2001 Tax Act has made qualified tuition savings programs more attractive than ever by allowing tax-free withdrawals from the plans to pay for qualified educational expenses. Qualified tuition programs, also known as Sec. 529 plans, are very beneficial for wealthy and middle-income families.

Sec. 529 college savings plans were established several years ago. Beginning this year, money in a Sec. 529 plan account grows tax-free, as long as the money in the plan is used for qualified higher education expenses, including tuition, fees, books, supplies or room and board.

Assets in the Sec. 529 plan not used for college will be subject to income taxes and the earnings will be subject to a 10 percent penalty, so you may not want to put in more than you know your child will use for college.

Relatives or friends can make annual contributions of up to $10,000 with no tax filing requirements. The plans are a great deal for many people, especially affluent clients, as it allows them to give large gifts, move assets out of their estate, and provide tax-free growth for their heirs benefit.


Some of the advantages of Sec. 529 college savings plans include:

* Withdrawal of earnings and principal from the plans is federal tax-free, as long as the money is used for qualified educational expenses. However, under the sunset provisions, distributions after 2010 are taxable.

* Annual earnings in the account are not taxable.

* Contributions of up to $50,000 per beneficiary may be made in a single year ($100,000 for a couple) without any gift tax implications, although a gift tax return must be filed for gifts over $10,000.

* There are no income limitations on contributions to the plan.

* The donor retains control of the assets, even if the assets are not ultimately used for higher educational expenses.

* Assets can be transferred without a penalty to a family member, including siblings and cousins.


Some of the disadvantages of Sec. 529 college savings plans include:

* The investment options are limited to the choices available in any state-sponsored program you choose. Most states have a program; California's is called ScholarShare.

* Donors cannot move money between the investment options within a plan. For example, if you choose the 100 percent equity option offered by ScholarShare when your child is two years old, and at age 15 decide that you want a more conservative investment, you will be unable to reduce your risk by switching options. At least one state has requested an IRS Private Letter Ruling asking that participants be allowed to move money between investment options within a state's plan.

Currently, there are three ways to switch investments:

(1) the donor could choose the age-based investment plan, where the investments are riskier (stocks) when a child is very young; as the child approaches college age, bonds and cash automatically are substituted for a portion of the equities;

(2) the donor could switch from one state's plan to another, but the switch can only happen once every 12 months; or

(3) future contributions can be earmarked into a more or less-risky investment option.

* Qualified withdrawals for California residents are taxable.


ScholarShare is California's state-sponsored plan managed by TIAA-CREF. California imposes state income tax on withdrawals from any Sec. 529 plan, however, if in the future California conforms to federal tax treatment, it's likely that only the California plan would provide the tax-free benefit for residents. If you like another state's plan better than ScholarShare today, you could invest in the other state's plan now, and move the assets to ScholarShare in the future. The maximum contribution that can be made to a ScholarShare account is $165,886.

ScholarShare currently offers four investment options.

* The Age-Based Asset Allocation Option invests in a combination of stock, bond and money market mutual funds with the percentage of holdings in these investments varying based on the age of the beneficiary. As the child approaches college, the asset allocation is weighted toward fixed income and cash.

* The Equity Option invests in domestic and international stocks.

* The Social Choice Equity Option avoids investing in companies that harm the environment, manufacture weapons, produce alcoholic beverages and tobacco products, produce nuclear energy or engage in gaming or gambling operations.

* The Guaranteed Option guarantees return of principal and a fixed rate of return.


Assets in a Sec. 529 plan account are considered for financial aid if the custodian is the parent or if the student is the account owner. However, the financial planning door opens to two opportunities:

* By making a grandparent, aunt or uncle the custodian, the asset does not come into the financial aid calculation.

* Since beneficiaries can be changed among family members, in households with more than one child, contribute to the youngest child's plan first. After the oldest child applies for financial aid and after the financial aid package has been awarded, the income of the student is no longer relevant. The donor can then switch beneficiaries by naming the oldest child. Timing is important and this strategy works best to fund the student's last year of college.


In general, the college savings plan is the best way to get a large amount of assets into a college savings vehicle. The Sec. 529 plans also allow a large amount of assets to be moved from a parent or grandparent's estate into a child's estate, to be used for college.

Annual contributions to an Educational Savings Account (formerly Educational IRA) are limited to $2,000. This amount is phased out beginning at $95,000 of income ($190,000 per couple). The advantage of Educational IRAs compared to Sec 529 plans is the wealth of available investment options. Educational IRAs can be established at brokerage houses, mutual fund companies and banks.

With a Uniform Transfers to Minors Act or UTMA account, you have the advantage of being able to choose your investment options, however, there are many drawbacks. First, the UTMA assets become your child's property when he reaches the age of majority. He can use the proceeds for college tuition, a red Porsche or anything else that he wants. Secondly, the earnings currently are taxed at the parents marginal tax rate under the kiddie tax rules.

The tax-free distribution feature of college savings plans is a giant advantage over accumulating assets in the parent's name, as earnings in the parent's account are currently taxable. However, assets in the parent's name can be self-directed for asset allocation purposes, and there is no limit to how much can be placed in the account.


Assets from an UTMA account would need to be sold before being transferred to a college savings plan, as the Sec. 529 plans can only accept cash. The minor would be subject to tax on any realized capital gain on the sale, taxable at the minor's tax rate or under the kiddie tax rules. The minor child would remain the owner of the new 529 plan, as UTMA assets were property of the child and must retain their original ownership.


Since there are so many Sec. 529 plans available, you'll need to determine which plan is appropriate for your client. For more information on the various state plans, check out For more information on ScholarShare, go to or call (877) 728-4338.

The power of compound earnings works best if you start early. Discuss these plans with your clients this season and give them a head start on planning for their children's future.

Joyce L. Franklin, CPA, CFP [TM] isa registered investment advisor and principal of Franklin Financial Advisors, a wealth management firm in San Francisco. She serves on CalCPA's Personal Financial Planning Committee and can be reached at
COPYRIGHT 2002 California Society of Certified Public Accountants
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Author:Franklin, Joyce L.
Publication:California CPA
Geographic Code:1USA
Date:Jan 1, 2002
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