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Stealing Harvard

The 529 tax-exempt, state-sponsored college savings plans aren't the no-brainer they appear to be

Not since 007 has a three-digit integer sounded so sexy.

Now it’s 529, the number of the federal tax code section that spawned state-sponsored college savings plans, that’s grabbing the attention. Thanks to last year’s Tax Relief Act, which stripped away the tax on plan distributions, 529 plans are increasingly becoming the vehicle of choice for paying for college.

That’s a marked change from the previous situation. Under past law, to be sure, parents could sock away money for college costs in state-sponsored plans and see it grow tax-free. But once those funds were tapped to pay for tuition, room and board, computers, and the like, the earnings were taxed at the student’s rate. Today, however, as long as funds are used to pay for eligible college costs, no tax needs to be paid to the feds.

Parents can also move money around among different state plans more easily. In the past, transferring funds to another plan without incurring tax consequences generally required parents to make another family member the account beneficiary. But now individuals can switch from state to state using the same beneficiary, rolling the funds over once every year. And parents can also diversify a 529 plan among multiple states.

Still, even someone with a CFO’s acumen needs to scale a steep learning curve to master how to make the best use of the plans. For starters, there are nearly 50 state-sponsored educational savings plans to educate yourself about, as well as the investment strategies available within each state. And a number of different investment managers run the plans. Putnam, for instance, offers its own stable of funds within the state plans it manages, while Manulife’s menu includes choices from T. Rowe Price and OppenheimerFunds. In the currently volatile stock market, striking the right balance between growth and security can be a more than academic challenge.

While each fund has different management strategies and past performance to consider, however, many states have similar products. Besides traditional stock and bond funds, many managers offer an age-based portfolio, which lowers the asset allocation risk the closer the child gets to 18.

Then there’s the issue of how to time your contributions to the savings plans. One particularly attractive provision is that each parent can contribute up to $11,000 per year per beneficiary (up from the prior $10,000 limit) and not owe any gift tax in the year.

On the other hand, each parent could choose to load five years of tax-free gifting at the front end with a $55,000 deposit. Grandparents take note: That’s a real advantage to those interested in getting money out of their estates as quickly as possible.

If you’ve got the cash, five-year, front-end loading seems like a great strategy, providing that much more time for tax-free growth as well as the gift tax advantage. But there’s a downside: Contributors might get only one year of the state income tax deduction they could get for a number of years were they to spread the payments. New York, for instance, allows each parent to deduct up to $10,000 a year for contributions to the state’s 529 plan. With a 10 percent tax rate, that’s $1,000 tax savings each year.


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