taxes

529 plan dropouts

Monday, Nov. 30
Posted 11 a.m. EDT

Numbers are always key to investments. But two important tax-favored numerical savings vehicles have been victims of major subtractions due to stock market turmoil.

First we watched the exodus from 401(k) retirement plans. People quit putting money into these tax-deferred workplace accounts. Many also took out what they had in their 401(k)s, either as loans or hardship withdrawals, to tide them over after they lost jobs.

Now we get word that parents are becoming 529 plan dropouts.

For those of you without kids, 529 plans (as with the 401(k), the name comes from the section of the tax code that created the accounts) have been a very popular way to save for a child's eventual college education. The main benefit is that earnings in the account accumulate tax-free. When you use 529 money to pay for qualified education costs, those distributions also are not taxed.

Plans are offered in every state and you aren't limited to just what's available in your neck of the woods. You can shop around and find the 529 that best fits your financial, and your kids' college, needs.

But apparently that cross-border choice isn't quite enough flexibility for some parents.

The Wall Street Journal reports that the recent market turmoil has prompted investors to seek more savings options.

The newspaper cites data from the Boston Research firm Financial Research Corp. that shows money going into 529s has dropped by two-thirds over the last few years. Parent put more than $15 billion into the college savings plans in both 2006 and 2007, but last year they contributed only around $5 billion.

Part of the reason for the major drop in 529 money is, understandably, the stock market's horrid returns over the last few years. Even with the promise of ultimately tax-free earnings, many folks couldn't stomach watching the value of their child's education account dwindle.

But the limits on the plans also are another reason folks are pulling back. In order for the money to be tax-free, it must be used to pay qualified higher-education expenses. Otherwise, you owe taxes and penalties on any withdrawals.

Alternate investment options: Some former 529 devotees have decided they'd rather take the money that would have gone into the college plan and use it for other purposes.

One parent interviewed by the Wall Street Journal, for example, opted to use the money to buy real estate near her son's college campus. That way, she reasoned, she'd have the property investment and her son would have a place to live.

I'm not a college financing expert; I've never even played one on TV. But I do worry about this trend of raiding savings, be they taxable or tax-deferred.

How many of the folks who quit contributing to a 529 plan actually made alternate educational savings provisions for that money? I fear not many, and that means lots of kids (and their parents) are going to have trouble in a few years paying for college.

Instead, I suggest folks consider the advice of Joseph Hurley, Bankrate's College Money Guru. Hurley notes that picking the right investment strategy to help pay educational needs depends on many factors, including the number of years before your kid heads to college, your risk tolerance and, of course, taxes.

"If your primary goal is protection of principal combined with a reasonable rate of interest, you may be better off looking for that combination within a 529 plan rather than turning to a taxable alternative," says Hurley.

Other educational tax breaks: A 529 is just one of several ways that the tax code helps you save for your child's education.

Coverdell Educational Savings Accounts were enhanced a few years ago. While the amount of money you can put into this type of account is relatively small -- only $2,000 per year -- you now can use the money to pay for more types of education expenses, including costs well before young Janie or Jimmy are college-bound.

And for 2009 and 2010 tax years, the American Opportunity Tax Credit could be worth up to $2,500.

Read more tax blogs.

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