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Section 529 plans smart for college savings

Section 529 plans have always been a good way for families to save for their children's college education. Recent tax and regulatory changes are making these savings accounts an even better choice.
/ Source: The Associated Press

Section 529 plans have always been a good way for families to save for their children's college education. Recent tax and regulatory changes are making these savings accounts an even better choice.

Section 529 plans, named for a section of the U.S. tax code, are tax-favored programs set up by states to help families save for tuition and other college-related costs. Savings in 529 plans grow tax-deferred, and withdrawals are tax-free when used for approved educational expenses.

Twenty-six states already give parents and grandparents a break on their state income taxes for some or all of their contributions to their own state's 529 plan. The District of Columbia offers a similar deduction for its plan.

Recently, Maine and Kansas announced that they would go further and give a state income tax break starting next year to families who make a contribution to any 529 plan, even those sponsored by other states.

Joseph F. Hurley, an expert on Section 529 plans who operates a Web site on saving for college, said "the tax law changes really affect only the residents of those two states, but it looks like it could be the beginning of a trend among states to open up their deductions."

He described the change as "a consumer friendly move" and said it "could create a more-level playing field by allowing people to choose a 529 plan based on which one they believe is best, without being swayed by the state tax benefits."

Hurley said many states also were working with their plan providers to bring down the expenses for investments, many of which are mutual funds; the efforts should result in better returns for savers.

Meanwhile, two other recent changes — one in so-called "kiddie tax" rules and the other in the Department of Education's financial aid formula — also will benefit Section 529 savers, experts said.

The kiddie tax rules were changed as part of the 2005 tax act, which President Bush signed in May, according to Bob D. Scharin, a senior tax analyst with RIA, a Thomson Corp.-owned company that provides tax information and software to professionals.

Under kiddie tax rules, a dependent child's income — typically from investments — can be taxed at the parent's rate if it exceeds a certain level, set at $1,700 in 2006, he said. The rules exist so wealthy parents in high tax brackets can't avoid taxes by shifting investments to their young children.

"Under prior law, this tax applied only thru age 13; at 14, excess gains were taxed at the child's lower rate," Scharin said. "Now, the new law raised that up to age 17."

This, Scharin said, should encourage some parents to take a second look at setting up Section 529 plans rather than custodial accounts created under the Uniform Gifts to Minors Act, UGMA, or Uniform Transfers to Minors Act, UTMA.

"With 529s, the income would not be taxed until it's withdrawn — and then it would be taxed only if it wasn't used for eligible education expenses," he said.

A parent or grandparent can contribute up to $12,000 a year to a child's 529 account without triggering the gift tax, or make a lump sum contribution of $60,000, also without tax impact.

Sophie Beckmann, a certified financial planner with A.G. Edwards & Sons in St. Louis, noted that the Deficit Reduction Act of 2005 made a substantial change in the way 529 plans were treated in determining student eligibility for federal aid.

Typically, assets of the parents are assessed at a 5.6 percent rate when determining eligibility, while student-owned assets such as UGMA and UTMA accounts are assessed at a much higher 35 percent rate.

Section 529 accounts usually are held in a parent's name on behalf of a child, and these will be assessed at the lower rate when determining aid qualifications, she said. Student-owned 529 accounts, meanwhile, will be excluded from the calculation "so they won't count against them at all for financial aid," she added.

"It clearly appears that Congress wanted to get people to take advantage of these (529) accounts more," Beckmann said.

One change that hasn't yet happened is that the tax incentives that make 529 accounts attractive were contained in the 2001 tax act and are set to expire in 2010.

Hurley of points out that there is broad support in the Senate to make the incentives permanent, but added: "It's not done yet."