Pension Bill Lifts 529 Cloud

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Pension Bill Lifts 529 Cloud
by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
July 2, 2007

The Pension Protection Act of 2006, signed into law by President Bush in August of 2006, lifts a major cloud previously hanging over 529 college savings plans—powerful tax-advantaged accounts that allow you to sock away upward of $200,000 per child.

Among other changes affecting employer plans and individual retirement accounts, the Pension Protection Act does away with the 2010 sunset provision that would have allowed tax-free 529 withdrawals to expire beginning in 2011. With the new law in place, qualified distributions from 529 plans will remain tax-free for as far as the eye can see.

What is a 529 college savings plan?
A 529 college savings plan is a state-sponsored program that allows parents, relatives and friends to invest for a child's (or any person's) college education. All states offer some type of 529 plan. However, in most cases you don't have to live in a particular state to take advantage of its 529 plan.

When you invest in a 529 plan, you can withdraw the money tax-free to pay for qualified education expenses—tuition, books, supplies, room and board, computer equipment and Internet service—at virtually any accredited college or university in the United States (and even some foreign schools).

A 529 account belongs to you, and your child is the beneficiary. Your money is combined with the money of other people saving for a college education and invested by a fund manager hired by the state to manage the plan. Most 529 college savings plans allow you to choose from a variety of predetermined asset allocation portfolios that range from conservative to aggressive, based on historic risk and potential return.

Your plan may offer a choice between an age-based portfolio and a static portfolio. With an age-based portfolio, the fund manager adjusts the asset allocation from aggressive to conservative as your child nears college age. With a static portfolio, the asset allocation stays the same until you make a change, which you can do once per calendar year.

What if your child's plans change? Or what if your child graduates, and there's money left over in your 529 account? You can change the beneficiary on the account to another qualified family member. Don't worry about finding a family member who needs money for college; the IRS broadly defines the term family member to include everyone from the original beneficiary's siblings and parents to step-siblings and in-laws.

Alternatively, you can simply withdraw the money from your account. Keep in mind, though, that you'll pay federal income taxes as well as a 10% penalty for nonqualified withdrawals.

How to open and contribute to a 529 plan
Parents, grandparents and other family members can open a 529 account on behalf of a child at a brokerage or other financial institution, or directly with a state. A child can be the beneficiary of more than one 529 plan at the same time, but you'll want to make sure the combined contributions don't exceed the contribution limit per state.

The typical initial investment to open an account ranges from $500 to $2,500. Many 529 plans allow you to open an account for less if you sign up for an automatic investing plan, with 529 contributions coming directly from your bank or brokerage account every month. Ask whether your company allows you to make 529 contributions automatically as a payroll deduction—many companies are adding this benefit.

There's no limit to how much you can contribute each year (though there are some tax considerations—see below). Instead, there's a lifetime maximum, which varies by state and generally ranges upward of $200,000 per beneficiary.

Tax and estate planning advantages
Earnings in a 529 plan grow federally tax-deferred, which means your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains.

Even better, withdrawals are tax-free as long as you use the money to pay for qualified education expenses (hang on to those receipts for at least six years!). Also, if you invest in your own state's 529 plan, you may benefit from state income tax deductions on contributions or state tax exemptions on withdrawals.

Here's another tax advantage: You can contribute a lump sum of up to $60,000 to one or more 529 plans in a single year (a married couple can contribute $120,000) without incurring the gift tax. The IRS views the money as an annual $12,000 (or $24,000 for spouses) gift over five years. However, if you contribute more money on behalf of the same child during those five years, you trigger the gift tax.

Effect on financial aid
Financial aid formulas consider 20% of the assets held in a child's name available for college expenses. But a 529 plan is considered your asset, not your child's—only 5.6% of the money is considered available for college expenses. What's more, if the grandparents open the 529 plan, it would not factor into initial financial aid eligibility at all.

Saving for college is a smart financial move, even if you believe your child may qualify for financial aid. Remember, the majority of financial aid comes in the form of loans, which must be repaid.

Important Disclosures

As with any investment, it is possible to lose money by investing in the Schwab 529 Plan. Before investing, carefully consider the plan's investment objectives, risks, charges and expenses. This information and more about the plans can be found in the Schwab 529 Guide and Participation Agreement available from Charles Schwab & Co., Inc., and should be read carefully before investing. If you are not a Kansas taxpayer, consider before investing whether your or the beneficiary's home state offers a 529 Plan that provides its taxpayers with state tax and other benefits not available through this plan.

The Schwab 529 College Savings Plan is offered through Charles Schwab & Co., Inc., and is managed by American Century Investment Management, Inc. The Plan was created under the provisions of Section 529 of the Internal Revenue Code by the Kansas Legislature and is administered by Kansas State Treasurer Lynn Jenkins, CPA. Accounts established under the Schwab 529 Plan are domiciled at American Century and not at Schwab.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. Individuals should contact their advisors to help answer questions about specific situations or needs prior to taking any action based upon this information.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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Schwab 529 Guide and Participation Agreement