17 Apr 2012

Saving For College On A Tax Favored Basis: The 529 College Savings Plan

Kids grow-up fast.  Before you know it, they are ready to embark on their college careers. Unfortunately, the cost of college tuition has escalated substantially over the last 20 years, placing a significant financial burden on parents, grandparents and students alike.

I recently performed an informal survey to find out what some California colleges are charging for in-state resident tuition. Here are the approximate tuition numbers for the 2011-2012 school year based on information contained on each school’s website (note that this is the cost of tuition alone and constitutes only a fraction of the overall annual college expense when combined with expenses for room and board, books, travel, entertainment, etc.):

Stanford University:                             $40,050 (for three quarters)

University of Southern California:       $42,162 (for two semesters)

University of California:                       $13,200 (for the school year – not including summer)

California State University:                  $5,472 (for the school year – not including summer)

Looking at these numbers makes me wonder whether it’s prudent for me to save my pennies to pay this tuition expense for each of my three children or whether I should invest a little extra time with my children helping them practice their gracious recitation of “would you like fries with that” to prepare them for their future careers in the fast food service industry. Fortunately for parents and grandparents who do decide to implement college savings plans for their children and grandchildren, 529 college savings plans are available to provide significant tax benefits. The reference to “529” in the title of the plan relates to Internal Revenue Code § 529, which authorizes these type of plans.

Two Types of 529 Plans.  There are two types of 529 plans. The first type of 529 plan, which is the most common type of plan, is a state sponsored plan that operates similar to a 401(k) plan where contributions are invested in various mutual funds.  The second type of 529 plan is a pre-paid tuition plan relating to payment for tuition to specific in-state colleges or private colleges.

California’s 529 Plan.  Each of the states in the United States sponsors a 529 college savings plan. The 529 college savings plan in California, known as the California Scholarshare College Savings Plan, is managed by TIAA-CREF, and can be found at www.savingforcollege.com. This is a wonderful website that provides a lot of information about the California plan and the different 529 plans established across the country. California residents are not limited to the California-sponsored plan and may invest in any 529 plan sponsored by another state. The savings in any state sponsored 529 plan account may be used for qualified educational expenses at any qualified college or university within the United States.

Benefits of a 529 Plan.  There are many benefits to saving for college with a 529 plan. Contributions to a 529 plan grow income tax-deferred, and distributions from the plan to pay for the beneficiary’s qualified educational expenses are not subject to federal income taxes.  Particular states may offer certain tax benefits as well for distributions from the 529 plan account.  The donor who creates the 529 plan account retains control, determines investment options, and decides when distributions may be made from the account. In fact, the donor has the right to retrieve all funds in the account at any time; however, the donor will have to pay income tax on the earning in the account and a 10% penalty on the earnings for taking them for a non-qualified use. Most states allow a donor to contribute up to $300,000 to the 529 plan account. California has a $350,000 limit for contributions to accounts under the California Scholarshare College Savings Plan.

The 10% Penalty.  As noted above, there is a 10% penalty on earnings for non-qualified distributions from a 529 plan account. The 10% penalty will not be imposed if the account is terminated due to the beneficiary’s death or disability, or if the withdrawn funds are not needed because the beneficiary has received a scholarship.

If funds remain in the account after the beneficiary no longer needs them for school, the 10% penalty may be avoided by changing the beneficiary on the account to another qualifying family member who may use the funds for qualified educational expenses.

Gift Taxes.  For gift tax purposes, each contribution to a 529 plan account is treated as a gift to the account’s beneficiary.  However, each contribution is considered a “present interest gift” and qualifies for the $13,000 annual gift tax exclusion. A donor may contribute up to $65,000 ($13,000 x 5) for a beneficiary in a single year and treat the gift as made over a five year period to qualify for the annual gift tax exclusion on the contribution for the current year and each of the four successive years.  This election must be made on a timely filed gift tax return.

Estate Taxes.  The donor receives a tremendous estate tax benefit by contributing to the 529 plan.  Typically, when a donor has the right to control a gift or even revoke it, the value of the gift will be included in the donor’s estate for estate tax purposes.  However, with a 529 plan, even though the donor retains control over the 529 account assets and can reclaim them at any time, the donor will be treated as if he or she transferred the assets out of his or her estate at the time the gift was made. The assets will not be included in the donor’s estate for estate tax purposes.  There is an exception to this rule if the donor front loads a contribution to the 529 plan account and elects it to be treated as if he or she made the contributions over a five year period and then dies during that five year period. The portion of the contributions scheduled to be treated as made in future years will be included in the donor’s estate for estate tax purposes.

Everyone planning to save for a student’s college tuition should consider investing in a 529 college savings plan to avail themselves of the multiple income, gift and estate tax benefits.


If you would like to discuss this or other trusts and estates issues, please contact the attorneys at Drucker Law Offices, 468 North Camden Drive, 2nd Floor, Beverly Hills, CA 90210, 310.285.5375 Tel, 310.444.9754 Fax, www.druckerlaw.com

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