Focus on Personal Finance
5-2-9 Means College Savings
The IRS has made it easier for you to set aside funds for hefty college expenses.

Here's good news for parents and grandparents: Internal Revenue Code (IRC) 529 offers a fairly painless way to build a substantial education fund for college-bound children.

IRC Section 529 provides for states to establish a "qualified state tuition program." The beauty of 529 is that it allows you to: (1) purchase tuition credits on behalf of a beneficiary (the college student), or (2) make contributions to an account that's established for the purpose of meeting higher education expenses (tuition as well as living expenses) of a beneficiary attending college on at least a half-time basis.

In this article, we'll focus on the second type of Section 529 plan. These questions and answers help explain how the plan works:

• Why is the IRS involved? The federal government is involved even though the plans are established by each state because there are federal income and estate tax advantages to using this method of saving. When you make a contribution to an account that you set up with your state, the funds are designated to be used for college expenses by the beneficiary you name. However, instead of you paying income tax each year on the account's earnings, the tax is deferred until the distributions are made to pay for college. And, to make the pie even sweeter, the earnings are taxed gradually, as the funds are used, at the student's income tax rate, which is almost always lower than yours. You've already paid income tax on the contribution, so only the earnings are taxed.

• How is the money invested after the contribution is made? Each state establishes funds, managed by investment professionals, who charge an annual fee to manage the assets. You choose from those funds, determining the proper asset allocation, according to your tolerance for investment risk. Some states offer funds that gradually become more conservative as the beneficiary gets closer to enrolling in college.

• How much cash can I contribute to the account? All states with these plans allow a $100,000 to $168,000 total contribution per beneficiary. But you don't have to contribute that much, and you can spread payments over a number of years if you start making contributions when a child is young.

• What if I contribute more than $10,000 to an account in 1 year? Will gift tax be assessed on the amount greater than $10,000? You may gift more than $10,000 ($20,000 if both husband and wife gift and elect gift-splitting) to one beneficiary in this type of account, and still not be assessed gift tax on the transfer. The law allows you to treat the gift as if it were made ratably over a 5-year period. Thus, an individual could contribute $50,000 in a year to a single beneficiary, and a married couple could contribute $100,000 in a year without triggering gift transfer tax.

• Can I change the beneficiary? Yes, but only to another college-bound individual in the same family.

• What if the beneficiary is awarded a scholarship? You may receive a distribution from the account equal to the scholarship without paying a penalty.

IT'S WORTH CONSIDERING

Overall, a 529 plan offers families a good deal. One caveat: If you tap into these funds for any other purpose but college, you'll pay a 10% penalty. For more information on how you can set up a college expenses account in your state, log on to www.collegesavings.org.

Richard J. Alphonso, JD, CPA/PFS, M.S.T., and Anita S. Frank, CPA, are president and tax manager, respectively, of The Financial Advisory Group, Inc., in Houston. The Financial Advisory Group provides personalized fee-only financial planning, investment management and business consulting services.