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Planning for the Future

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According to the College Board (2009), college tuition rates are expected to increase at rates of five to eight percent each year. The cost of one year’s tuition at a public university currently averages $6,585 (College Board, 2009). At a rate of five percent per year, tuition could be increased by $329 each year. Imagine a child who has 15 years before attending college. Is it better to pay $6,585 or $11,520 per year? Fortunately, there are many options available to assist families in saving for future college expenses. When it comes to preparing and paying for college, one option is to start a Qualified Tuition Program, which guarantees current tuition rates and provides tax free savings.
Qualified Tuition Programs were created in 1996 by Internal Revenue Code (IRC) 529 (Internal Revenue Manual, 2009). IRC 529 sets forth requirements plans must meet in order to receive federal tax exemption status for Qualified Tuition Programs. These types of programs are commonly referred to as ‘529 plans’ because of the code number they were created under. According to IRS Publication 970 (2009), a Qualified Tuition Program is any “program set up to allow you to either prepay, or contribute to an account for paying, a student’s qualified education expenses”. These programs are set up and maintained by states or eligible educational institutions. There are two types of plans; Prepaid Qualified Tuition Programs and Qualified Tuition Savings Programs.
Prepaid Qualified Tuition Programs allow for the purchase of credits in the name of a designated beneficiary. With a prepaid plan, there is a guarantee that a credit of tuition purchased today will cover a credit of tuition at the time the beneficiary chooses to attend college (U.S. Securities and Exchange Commission (SEC), 2007). Some prepaid plans have age limitations that restrict when a child can be enrolled and others do not. Contributions to prepaid 529 plans are not limited but there are safeguards that prevent the account balance from exceeding what is considered necessary for qualified expenses. Prepaid plans are compiled by the individual states offering them and there are only two states that do not have residency requirements (Todorova, 2009). The Qualified Tuition Savings Program allows a person to contribute cash to an account that is then invested by the program’s manager and directed by the account holder. No matter which state a savings plan is setup in, there are no age restrictions for beneficiaries. There is no limit on the amount that may be contributed to an account during the year. Investments earn interest and add to the contributed balance in the account. The balance is used to pay for qualified educational expenses when the beneficiary attends an eligible institution. There are no residency requirements for a savings plan in any state (SEC, 2007). Plans are held in the name of the designated beneficiary that the funds being contributed are intended for. No matter what type of 529 plan is setup, a beneficiary must be named. Only the beneficiary may authorize withdrawal of funds. There are occasions when the beneficiary must be changed. This can include death or permanent disability of the beneficiary, or they do not wish to attend college. The new beneficiary must be considered a member of the family in order to avoid additional fees. The definition of family includes traditional dependents, beneficiary’s spouse, spouses of dependents, and first cousins, (Hulse & Harden, 2003).
529 plans are exempt from federal taxes. The initial investment is made from after tax dollars. Once funds are contributed, the accrual of interest does not incur any tax charges. During the life of the account, it is not reported as income. Another benefit is that any person who contributes does not have to pay gift taxes as long as the dollar amount does not exceed $11,000 for those filing singly. Funds withdrawn from the account to pay for qualified expenses are exempt from any federal tax charges. Thomas L., a participant in Illinois’s 529 plan, said, “It was important to pay for college using tax-free dollars.” (College Illinois, 2009).
When setting up the plan, it is important to know that it may be created in any state. “While I always advise looking first at your own state's 529 plan, I also encourage shopping around to see if another state's 529 plan might be a better fit.” says noted 529 plan expert Joe Hurley (Saving for College, 2007). This is important because the state in which the 529 plan is invested determines whether there are any state tax charges or not. Many state sponsored plans can be transferred to other states. If the plan is transferred to a different state, both states have the right to assess state taxes on the funds.
The account holder decides which state the plan will be active in. Each state offers different plans. For example, Washington offers only one 529 plan; the Guaranteed Education Tuition (GET) plan, which is a prepaid tuition plan. Nevada offers five plans; the Nevada Prepaid Tuition Program, Vanguard 529 College Savings Plan, Upromise College Fund 529 Plan (savings), USAA College Savings Plan, and the Columbia 529 plan (savings). Each type of plan has features, benefits, and costs that vary. It is important to compare all available options before settling on a plan.
Withdrawals can be made for qualified educational expenses. The most common expense is college tuition and associated attendance fees. Any tuition and fees paid to attend an eligible educational institution are considered qualified expenses. Textbooks and supplies are the second most common qualified expenses. A beneficiary who attends school more than half time may also be able to qualify room and board expenses. Room and board expenses must be a reasonable cost as determined by the institution. Not all expenses are considered qualified. When a beneficiary attends school less than half time, room and board costs are not deemed qualified expenses. Room and board costs may include students who live in off campus housing. These costs will only be met at the figure stated in the institution’s budget. Any costs over the school’s budget are deemed non-qualified expenses. Any student living at home cannot qualify funds for room and board. Funds withdrawn from the account for non-qualified expenses incur penalty charges. The money withdrawn beyond qualified expenses would be subject to any current federal, state, and/or local tax charges (FinAid, 2009). These charges are at the tax rate for the year the withdrawal was made, not the year in which the money was deposited. There is also a 10% penalty fee on the funds. For example, if $100 is withdrawn for non-qualified expenses, a $10 penalty fee must be paid. This fee is waived in the case of a beneficiary’s death, disability, or if scholarships are received. Financial aid eligibility may be affected by 529 plans. Need-based aid is calculated from the income and assets of students and parents. Distributions do not count towards either student or parental income. The balance on account is considered a parental asset for both prepaid and savings plans. Any money invested in a prepaid program directly reduces the amount of need-based aid (Kiplinger, 2007). A savings program is considered a regular investment which means that need-based aid is reduced by 5.6% of the balance (Kiplinger, 2007). Though a beneficiary has funds invested in a 529 plan, it will not affect their eligibility for many scholarships. Scholarships that are not affected include athletic, academic, departmental, and private organization awards. These awards are based on the merit of the student in the area the scholarship specializes in. Scholarships that are awarded based on the student's need may be affected. Students should still apply for and use scholarships as an option to pay for college. Left over funds in the account due to scholarship awards may be withdrawn penalty free, but not tax free, or transferred to another beneficiary. The best way to take advantage of all the benefits a 529 plan offers is to set one up for a beneficiary at a young age. The younger the beneficiary is the more money can be invested. Another way to take full advantage of the benefits would be to use the funds only for qualified educational expenses. This ensures there are no additional tax charges and the 10% penalty fee will not be assessed on the funds withdrawn.
Each plan’s start up and contribution costs vary, so it is beneficial to verify this information before settling on a particular plan. Researching all available plans and options is the most important thing that can be done in order to ensure the best benefits are received. 529 plan expert Howard S. Gartenhaus believes that “A qualified advisor can determine which plan features are most important to them and then make a specific recommendation that will satisfy their needs and help achieve their goals.” (2004). At an inflation rate of five percent annually, the cost of a college education at a public university for one year will be twice the cost it is today. The ability to guarantee current tuition rates as well as take advantage of tax free savings and withdrawals will help families to be better prepared to pay for college expenses. 529 plans are a viable savings option and should continue to grow in popularity and usage through the coming years.
References
College Board. (2009). 2008-09 college prices. Retrieved March 17, 2009 from http://www.collegeboard.com
College Illinois. (2009). Testimonials. Retrieved March 27, 2009 from http://www.collegeillinois.com
FinAid. (2009). Saving for college. Retrieved March 16, 2009 from http://www.finaid.org
Financial Aid for College. (2004, April 1). Expert college savings plan advice. Retrieved March 27, 2009 from http://www.financialaidforcollege.com
Hulse, D., Harden, J W. (2003, January). Assisting clients in college education funding choices: A framework for comparing alternatives. Journal of Financial Service Professionals, 57(1), 74-84. Retrieved March 11, 2009, from ABI/INFORM Global database. (Document ID: 275008421).
Internal Revenue Service. (2009, January 14). Internal revenue manual. Retrieved March 11, 2009 from http://www.irs.gov
Internal Revenue Service. (2009, January 6). Publication 970 (2008), tax benefits for education. Retrieved March 11, 2009 from http://www.irs.gov
Kiplinger. (2007, August). State-sponsored college savings plan. Retrieved March 18, 2009 from http://www.kiplinger.com
Saving for College. (2007, April 4). Using out-of-state 529 plans. Retrieved March 27, 2009 from http://www.savingforcollege.com
Todorova, A. (2009, February 5). A better way to save for college. Smart Money. Retrieved March 27, 2009 from http://www.smartmoney.com
U. S. Securities and Exchange Commission. (2007, August 6). An introduction to 529 plans. Retrieved March 11, 2009 from http://www.sec.gov/index.htm

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