The Need

Anyone who has looked into the cost of sending a child to college is aware of the high price of higher education. That cost continues to grow at a greater-than-inflation rate of about 6% annually. Contributing to a qualified tuition program (QTP, also known as a "Section 529" plan) is a very attractive and tax-advantaged way to help fund that education. It is a strategy worthy of consideration by both parents and grandparents.

Two Types of Plans

There are two types of Section 529 plans ~~ prepaid tuition and college savings. Under the prepaid-tuition plan, contributions are used to prepay college expenses, at today’s tuition rates, for a designated beneficiary (student) at state schools within a specific state or, with recent tax law changes, at eligible private institutions. With the college-savings plan, contributions are made to an account established to pay the qualified college expenses of the beneficiary. Distributions from the account can be used at any accredited school in the country. These latter plans are considerably more flexible than prepaid-tuition plans and are preferred by most people. Additionally, New York State is one of the 32 states that does not offer a prepaid-tuition plan.

Federal Income Tax Advantages

Starting in 2002, Section 529 plans became much more attractive, thanks to federal income tax legislation enacted in June of 2001. Qualifying distributions are now tax-free federally. Formerly, earnings were taxed to the student upon withdrawal. With the new law also allowing private educational institutions to sponsor prepaid-tuition programs, benefits from these programs are tax free federally starting in 2004. Qualifying distributions/benefits are those used to pay for tuition, fees, books, supplies, equipment, and room and board at eligible institutions. For distributions not used for higher education, earnings are taxed at ordinary rates (both federal and state), and there is a 10% penalty when the earnings are withdrawn.

A particularly attractive feature is the lack of any income restrictions on contributions and on the tax-free treatment of qualifying distributions. There is no income cap or phase-out range.

The New York State College-Savings Plan

While donors are free to establish and contribute to a college-savings plan in one or more states (almost every state now has one), New York residents should first consider the New York State plan. It is a very attractive plan administered by Upromise Investments, Inc. with investment management services provided by the Vanguard Group. It is the only college-savings plan that allows NY state tax deductions for total annual contributions of up to $5,000/year for singles ($10,000 for married couples filing jointly). And, similar to the federal provisions, qualified distributions, including earnings, are tax-free (also true in New York for withdrawals from other states’ plans). Contributions for any one beneficiary (student) may continue to be made as long as the total account balance for that beneficiary is $235,000 or less. There are fifteen investment options available – three age-based asset allocation options, eleven Vanguard stock and/or fixed-income portfolio options, and a Vanguard interest-accumulation portfolio option. The donor/account owner makes the investment option(s) choice, which may be changed as often as once a year.

The New York State Plan has no enrollment or annual maintenance fees. The annual investment management fee is a modest 0.6%.

Beneficiary and Account Owner Flexibility

Should a beneficiary decide not to attend college, the beneficiary designation for a Section 529 plan can be transferred by the donor/account owner, without penalty, to another family member, including cousins or even the donor him/herself. And, the account ownership can be transferred on death via a separate beneficiary designation.

Gift and Estate Tax Benefits – Grandparents take Note!

A contribution to a Section 529 Plan is a taxable gift, eligible for the annual exclusion from gift tax, currently $11,000. In addition, a special forward-averaging provision permits the application of 5 years of exclusions from a single contribution to a donee ~~ $55,000 (or $110,000 for a married couple) in any year. Furthermore, 529 Plan contributions and associated earnings are excluded from the donor/account owner’s estate, even though the donor still retains considerable control over the account, including the right to change the beneficiary. An exception applies if the donor dies during the 5-year averaging period for the annual exclusion. In this case, the taxable estate includes the gift amounts allocated to periods after his/her death.

These gifting features offer grandparents, in particular, an attractive way to remove considerable sums from their estates, establish accounts to help fund their grandchildren’s college education, yet redirect those funds (either directly or through subsequent account owners) if the original beneficiaries do not need or use these funds for college or, quite simply, if the donor/account owner changes his/her mind.

Additional Information

A wealth of information on Section 529 Plans exists. Three particularly useful references are:

http://www.savingforcollege.com/  Website containing comprehensive description of Section 529 Plans plus a summary of the plan for each state

http://www.nysaves.org/  New York State College Savings Program website, including a summary of the NYS plan plus an online account application

[email protected]  Direct e-mail link to James Terwilliger, VP, CERTIFIED FINANCIAL PLANNER™, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext 50630.  Jim is available to help answer your questions and provide assistance in establishing your account(s).