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Pension law: permanent 529 tax exemption
Dear
College Money Guru,
I have heard that Congress made the
tax exemption for 529 plans permanent. Is that true, and what does it mean for
those of us who are weighing whether to go with a 529 plan versus other types
of savings to fund education?
-- J.W.
Dear
J.W.,
You heard right. Buried among the 900-plus pages of the Pension
Protection Act of 2006, passed by Congress and signed into law by President Bush
on Aug. 17, 2006, is a single sentence that removes the 2010 expiration of the 529 tax
exemption.
This new development should come with a sense of
relief and excitement for all families with children. A 2001 tax law -- Economic
Growth and Tax Relief Reconciliation Act, or EGTRRA -- made withdrawals from a
529 plan completely tax-free when used for college, but established a "sunset"
date of Dec. 31, 2010. Ever since then, I've been trying to assure investors that
Congress would eventually defuse the time bomb. But assurances are not the same
as guarantees. Now that it's actually happened, 529 plans will no doubt see a
surge in contributions.
While 529 plans are not necessarily the best choice
for every college saver in every situation,
they must be placed high on everyone's list
of alternatives. The federal tax benefits are
difficult, if not impossible, to beat. And most
states tack on additional incentives, including
state deductions for contributions and, in some
cases, matching contributions. Of course, it's
up to you to select which 529 plan(s) to use,
and within any 529 plan you'll have a menu of
investment options from which to choose. Prepaid
tuition plans also qualify for 529 tax treatment.
Taxable mutual funds become relatively
less attractive as a college-savings vehicle.
Sure, you have thousands to choose from and
you won't be at risk for the tax and 10 percent
penalty incurred on 529 withdrawals not used
for college. But any earnings are subject to
tax, and they can also have a substantial impact
on financial-aid eligibility. Even if the gains
are eligible for the low tax rates on capital
gains and dividends, you should be prepared
to see these rates increase in 2011.
Thinking about gifting those funds
to your child and shifting the gains onto his
or her return? Think again. The "kiddie tax"
could foil those plans. This law was created
to prevent asset shifting from parents to their
children in lower tax brackets. Congress has
been steadily reducing this option by raising
the age at which the "kiddie tax" applies. Currently,
youngsters 18 or younger, or 23 or younger if
they're full-time students, will be subject
to the kiddie tax.
How about Coverdell education
savings accounts, now known as education savings
accounts or ESAs? You really can't go very far
with them. Even if you see a way to save on
expenses -- 529s generally charge a modest management
fee -- you'll be giving up any state income
tax deduction that may come with your state's
529 plan. You're also be facing age and income
restrictions and a $2,000 per child annual contribution
cap. What's worse, ESAs are still facing a 2010
sunset on several important changes made in
2001. Because of that sunset, you'll probably
decide to roll over your ESA balances into a
529 plan at some point anyway.
If you're confident you'll be using the money for college,
you can't go wrong with 529 plans. Take the
time necessary to learn the rules -- they're
not all that difficult. Then focus your efforts
on finding the 529 plan that best meets your
own preferences and objectives.
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