Q: What are the benefits of funding college education through 529 plan accounts rather than trust accounts or UTMA accounts?
A: Under the terms of the Economic Growth and Tax Relief Reconciliation Act of 2001, qualified withdrawals from 529 plan accounts are tax-free. Not tax-deferred. Tax-free. In other words, if you invested $25,000 in a 529 plan account today, and that account grew to $50,000 by 2008, at which time you began withdrawing funds from the account to pay your children’s college expenses, all of those withdrawals would be tax-free. Under the tax law as it exists today, you would never pay any taxes on the $25,000 of growth in that account. Another major benefit is that 529 plan accounts remain under the control of the participant. While UGMA and UTMA accounts automatically become the property of the beneficiary when he or she reaches legal age, even if that child does not attend college, the participant in a 529 plan account can change the beneficiary of the account or remove the funds if a child does not attend college.

Q: It sounds too good to be true, what’s the catch?
A: The only catch at this point is that if the Economic Growth and Tax Relief Reconciliation Act of 2001 is repealed or revisited, these advantages might be altered or eliminated. The Economic Growth and Tax Relief Reconciliation Act of 2001 does have a “sunset provision.” As a result, unless it is reenacted, all of the tax law changes contained within it (including the actual tax rate reductions, increases on limits to 401(k) and IRA contributions, and the tax-free withdrawals from 529 plan accounts, just to name a few) will automatically end on December 31, 2010. As of April 2002, legislation was pending before Congress to make permanent the tax law changes of the Economic Growth and Tax Relief Reconciliation Act of 2001.

Q: Are there income level or residency restrictions on 529 plan accounts?
A: No. Anyone can open a 529 plan account, regardless of income, age or state of residency.

Q: Should I generally enroll in the 529 plan program of the state in which I reside?
A: Not necessarily. While there are additional benefits to residents that vary from state to state, because the investment options in 529 plans are limited to preselected portfolios, other factors, such as fund performance and contribution limits, may actually be equally or more important than the additional benefits available to state residents. In Illinois, contributions to a Bright Start account are deductible from state income taxes.

Q: What kinds of 529 plan accounts are there?
A: There are two basic types of 529 plan accounts. The first type is “Prepaid Tuition” programs. See IRS Code Section 529(b)(1)(A)(i). These give you the ability to pay a set amount now and be ensured that a child’s tuition is paid for in the future based on the tuition rate at a given institution. The second type of 529 plan account is an investment account in which savings are accumulated over a period of years and the funds used later to meet college expenses as they arise. Each state has its own particular arrangements as to what investment portfolios are available and through what brokerages. Typically, states have a pre-selected set of investment portfolio options, so there is less investment freedom than in a simple brokerage account. However, given the wide variety of programs that exist from state to state, there are still a great number of investment options available through 529 plans currently. It is not necessary to enroll in the savings plan of the state where the parents reside, and the funds can be used at any qualified institution across the country. Differences also exist from state to state as to the state taxation of withdrawals, contribution limits and the deductibility of contributions.

Q: How much freedom do I have to direct the investments within the 529 plan account that I open?
A: IRS Code Section 529(b)(4) provides that a contributor or beneficiary may not directly or indirectly direct the investment of any contributions to the program. As a result, you will not be able to select specific equities for your 529 plan account. However, almost all 50 states have 529 plan programs in place, and most of these programs offer multiple investment vehicles. Thus there are a great number of investment portfolios available through a number of different brokerages. Many of the programs offer age-sensitive investment portfolios that shift the beneficiary’s account from a growth-oriented portfolio to an income-oriented portfolio as the child approaches college age. You can also change from one investment portfolio to another within the program without incurring any taxes on the gains accumulated.

Q: What are the qualified purposes that allow for the tax-free withdrawal of these savings?
A: Tuition, room and board, student fees, and some school equipment. Limitations on qualifying room and board expenses have recently been expanded.

Q: What happens if the funds are withdrawn for non-qualified purposes? For example, if a child does not end up going to college?
A: In this case, the recipient on the withdrawals incurs a 10% federal income tax penalty and the earnings on the account are taxed as ordinary income. However, keep in mind the scenario described above. You invest $25,000 in 2002 in a 529 plan investment account. From time to time you alter the investment portfolio within the investment account, which grows to $50,000 by 2008, incurring no taxes during the intervening years on these transactions. In 2009, the account is worth $50,000 and the child the account was set up for elects not to attend college. So you remove the funds and incur the 10% tax penalty and the gains generated on the account are treated as ordinary income. Your net taxes paid may still be less, despite the penalty, than if the money were simply invested in a brokerage account in 2002 and you paid tax on the gains arising from transactions from year to year. In other words, the benefits of deferring these taxes may actually outweigh the cost of the tax penalty incurred years later. Alternatively, if the child the account was intended for does not go to college when expected you can change the beneficiary on the account or let the funds sit to see if the child decides to go to college later (as, in most states, there are no age restrictions on 529 plan accounts).

Q: Can existing UTMA accounts and trust accounts be transferred into 529 plan accounts to take advantage of these tax benefits?
A: Yes, funds from UTMA accounts may be transferred to 529 plan accounts. However, it may be necessary to segregate these funds into a separate account to ensure compliance with UTMA regulations. If you do this, the beneficiary is still considered the account owner and will be able to withdraw the funds upon reaching the age of majority. Also, you may not change the beneficiary on the account if the funds are transferred from a UTMA account. In other words, the control problems inherent to UTMA or UGMA accounts are not avoided by transferring funds in these accounts into a 529 plan account. Trust funds can also be rolled into 529 plan accounts, so long as doing so does not conflict with the terms of the trust.

Q: Can I put other assets into a 529 plan account, such as stocks or real estate?
A: No, pursuant to Section 529(b)(2), “A program shall not be treated as a qualified tuition program unless it provides that purchases or contributions may only be made in cash.”

Q: Who may be the beneficiary of a 529 plan account that I establish?
A: A wide variety of family members qualify in addition to sons and daughters of the participant. In many states, you can even open a 529 plan account for yourself if you intend to go back to school. The ability to change the beneficiary is another advantage of a 529 plan account. For example, assume a situation in which parents have one child whose entire college costs are met from savings accumulated in a 529 plan account. At the end of that child’s college career, $15,000 remains in the account. The beneficiary of the account may now be changed into a niece or nephew or the contributing parent. Alternatively, the parent could make his or her spouse, who wishes to attain a graduate degree, the beneficiary of the account. As a result of this flexibility, a 529 plan account can essentially become a permanent family education fund that does much more than just meet its primary purpose of meeting the children’s college education expenses.

Q: We have two children. Can we open one 529 plan account naming both of them as beneficiary?
A: No, with 529 plan accounts, there can only be one beneficiary for each account. As a result, if you have more than one child and wish to take advantage of the benefits of 529 plan accounts, you should open up a separate account for each child. Keep in mind, however, that if one child does not attend college, it is easy to change the beneficiary on that child’s account to the child who is attending college, or to another family member. The beneficiary of a 529 account can be changed once every twelve months to another qualifying family member without being considered a distribution.

Q: How much can be contributed to a 529 plan account?
A: Contributions to a 529 plan account are considered to be completed gifts to the designated beneficiary. However, it is possible to front-load a 529 plan account with up to $110,000 from a married couple ($55,000 for an individual) and to shelter this front-loading from gift-tax reporting by using five years’ worth of annual gift tax exclusions. It is worth noting that if the plan participant dies before the five-year period expires, then a prorated portion of the contribution will be included in his or her taxable estate. While Section 529 of the IRS code does prohibit “excess contributions” to 529 plans, most state limitations on 529 plan contributions are quite high and are based on expected total costs of a college education at a “baseline” institution selected by that state’s program. As the costs of the “baseline” institutions vary dramatically, there is wide variation from state to state as to the total amount of contributions permitted into 529 plan accounts. Once a 529 plan account reaches the “baseline” amount, no further contributions to the account are permitted.

Q: My kid is brilliant and is going to get a scholarship. What happens to the money then?
A: First, you can use the money in the 529 plan account to cover qualified costs that are not met by the scholarship, such as room and board, books, fees and equipment. Of course, you can always change the beneficiary of the account or let the money sit until your brilliant kid starts grad school. Alternatively, you can withdraw an amount from the account equal to the value of the scholarship without incurring the 10% penalty on nonqualified disbursements. The earnings on the amount withdrawn in this situation are taxed as ordinary income.

Disclaimer: Keep in mind that every state’s 529 plan program is different. As a result, for any rule that exists in relation to 529 plans, there is an exception. For example, some states do not allow individuals to set up 529 accounts for themselves, while others do have age restrictions. A qualified financial planner can help you (or your client) select the 529 plan program that is right for your situation, and can guide you through the idiosyncrasies of a particular state program.