When not to use a 529 plan

Now that there are so many 529 options available, should you switch your college-savings accounts such as custodial plans to a new 529 plan so qualified withdrawals can be made tax-free?

That depends, says Joseph Hurley, a Bankrate adviser and founder of (a Bankrate company), a Web site on financing a child's college education.

"If you're in a 15-percent tax bracket or lower, you may actually be better off in a taxable fund," Hurley says.

That's because 529 plans charge fees that other accounts don't. And if you're in a low bracket, tax-free withdrawal is less of an advantage.

"You should compare the extra costs in the 529 plan to the tax benefits it provides, and if the tax benefits don't outweigh the extra costs, the 529 is probably not something you want to use," Hurley says.

What's more, if your custodial account is invested in a stock index fund, any profits you withdraw will be taxed as a capital gain. The capital-gains tax rate is typically lower than the income tax rate you'd face from an interest-producing account such as a bond fund.

"If you're in a tax-efficient, equity-index fund, and you don't have to pay the extra costs of the 529 plan, you might be better off in the custodial account," Hurley says.

A custodial account is a savings plan set up for a minor who takes ownership upon reaching adult age -- age 18 or 21, depending on the individual state's rules. You can withdraw funds anytime as long as they are for the designated child's benefit. When the child reaches adult age, he or she can withdraw funds for any purpose.

Taxes on custodial accounts are assessed each year as follows: If the child is older than 19 and not a full-time student at year-end, investment income is taxed at the child's's rate. Otherwise, through age 23 the first $950 of income is tax-free, the next $950 is at the child's rate, and any income above that is at the parent's rate.

One important factor about custodial accounts is they give you more flexibility than a 529 to withdraw money for purposes other than higher-education costs. Hurley says 529 withdrawals must be for qualified education expenses only. If not, the earnings incur a 10-percent penalty plus taxes. Those taxes on unqualified withdrawals are assessed at the recipient's federal income-tax rate, whether the recipient is the parent or the child.

A custodial account gives you more flexibility than a 529 to withdraw money for purposes other than higher-education costs. Hurley says 529 withdrawals must be for qualified education expenses only. If not, they incur a 10-percent penalty plus taxes.

But what if you have two or more children? Is it really necessary to hold a separate 529 for each child? That is, can't you have just one 529 plan and when the time comes, dole out a portion for one child, then change the beneficiary and dole out the rest for the other child, thus saving on 529 fees?

"Generally, I recommend separate accounts for each child because they are different ages," says Greg Merlino, president of Ameriway Financial Services, a financial advisory firm in Voorhees, N.J. "The younger child would have a more aggressive portfolio because he or she has a longer time before college starts, and you would be more conservative for the older child who is nearer college age."


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