There are about 70 million children under 18 in the U.S. but less than six million have 529 college savings accounts. The low market share may be due to these areas of uncertainty:
- Income taxes. Although 529 plans now allow income tax-free withdrawals for higher education expenses, such withdrawals might become taxable after 2010. The tax law is now scheduled to revert to the law in effect in 2001, when withdrawals were taxed at the student’s rate.
- Moreover last year’s tax law included tax-rate cuts on dividends and capital gains, which slightly reduced the advantages of 529 plans. Now, it’s possible for parents to invest on their own, or in a child’s name, and pay tax at modest rates.
- Yet another alternative to 529 plans may be available soon. President Bush’s tax proposals, unveiled in February, included the creation of Lifetime Savings Accounts (LSAs), which might draw contributions away from 529 plans. As proposed, LSAs would allow everyone to enjoy tax-free buildup and tax-free withdrawals for all purposes, including but not limited to higher education.
- Estate taxes. Many investors have found that 529 plans are useful for estate planning. Assets donated to a 529 account are out of your taxable estate but they can be reclaimed if the need arises, as long as you are willing to pay tax and a 10 percent penalty on any earnings. Current law permits taxpayers to make up to five years’ worth of upfront, tax-free gifts via 529 plans, at $11,000 per year.
- Such planning may or may not be necessary, depending on how future legislation deals with gift and estate taxes. In addition, President Bush’s proposals include some “anti-abuse” measures aimed at 529 plans. Beneficiaries could be no older than 35, large non-qualified withdrawals would be subject to steeper penalties, and gift-tax rules would become less favorable.
- The proposal grandfathers 529 accounts in effect as of the date any law is enacted. Thus, if such legislation is passed there would be “old” and “new” 529 accounts, with the new ones somewhat less attractive than their predecessors.
- Financial aid. Currently, if the parent is the owner of a 529 account, some of the money there will be expected to be used for college so financial aid may be reduced, albeit modestly. However, if the account is owned by someone who’s not the parent or guardian, such as a grandparent, the 529 plan never gets looked at.
Again, the future outlook is cloudy. There might be a question on future college aid forms, asking about 529 plans. These accounts could be treated as a child’s asset, which count heavily to reduce the aid provided to students.
Many advisors say that a 529 plan may be useful for education funding but should be used with other holdings, such as custodial accounts and securities owned by the parents.