STERN ADVICE-How to hack your 529 college savings plan
WASHINGTON, Sept 18 (Reuters) - Americans fling more than $30 million a day at 529 college savings plans, and no wonder - the plans provide some sweet tax savings, a variety of investment choices and the satisfaction that you're doing something for the kids.
These plans, sponsored by almost every state and the District of Columbia, allow savers to accumulate money their children use for college. Contributions don't get any federal tax breaks, though some states offer tax incentives to participants. When the money is withdrawn to pay for qualified college expenses, it is not taxed - so all the money earned within the 529 over the years is tax-free income.
But wait, there's more. The 529 is a creation of federal tax law and so joins others - like the home mortgage deduction and the writeoff for health savings accounts - that crafty taxpayers can take beyond their stated purpose and capitalize on if they know how to play the game.
The home mortgage deduction, for example, spawned home equity lines of credit, which have bankrolled everything from home improvements to vacations. And those health savings accounts - designed to help savers accumulate enough to cover their high deductibles and co-pays - now serve as back-door retirement plans for some savvy savers.
And so it is with 529 plans. Open one for junior when he's little, feed it regularly, and you'll be happy to have a pot of tax-free savings when it is time to matriculate. (One word to the wise: Keep the account in your name, and name your child the beneficiary, to avoid the funds hurting his financial aid eligibility.)
But that is just the way it's supposed to be used. Here are some other ways to benefit from a 529 plan:
- Buy one for a very short term. What if you are already in grad school and don't have a 529 plan? If you live in a state like Pennsylvania or New York, which offer generous state tax deductions for contributions, you can put the money in a 529, collect the deduction and then turn around and spend it almost immediately on your next tuition bill. Some states require a one-year holding period, some don't. Go to SavingForCollege.com to find the rules in your state.
- Buy one without a particular use or person in mind. Maybe your child just finished college and doesn't know whether she will go to grad school or will have kids. So what? There's a decent chance she will do one or the other, if not both. You can open a 529 for yourself and later name her or her progeny as the beneficiary.
The advantage to that? Short-term flexibility - to use the money for yourself, her grad school or some future grandchild - and really long compound interest. Put $100 monthly into an account earning 7.5 percent, and you'll accumulate $45,720 in 18 years. Let it run for 25 years, and you'll have $88,331. If your daughter doesn't have kids or go back to school, you can transfer the plan to another relative. (The only thing you don't want to do is withdraw the money for a non-qualified educational purpose - then you'll have to pay a 10 percent penalty and income taxes on the earnings you take out.)
- Consider it a back-door estate plan. Switching a 529 plan's beneficiaries to another generation can trigger gift and estate taxes, so you have to be strategic. In the case above, for example, if your account had grown to more than $14,000, you wouldn't be able to move all of it to a beneficiary in the next generation at once. But you could move $14,000 a year (indexed for inflation) to a new beneficiary without even starting to reduce your lifetime gift and estate tax exclusion. To avoid having to change beneficiaries on a large account, you could start to switch the beneficiaries as soon as the next generation is born and they would still benefit from the long-term compounding you set in motion.
- Buy one for yourself. Maybe you just finished college and don't even want to think about more tests, or maybe you are mid-career. Your own 529 can pay for that mid-career MBA or classes you decide to take as you head into retirement. Joseph Hurley, founder of the SavingForCollege website, is, at 57, using his 529 to study horticulture at his local community college as he prepares for his avocation/next career as a beekeeper, maple syrup producer and shiitake mushroom grower.
- Buy 'em by the bunch. There's no compelling reason, other than simplicity, to have only one 529 - or even one per beneficiary. At one point, when his kids (now through college) were younger, Hurley had 34 of them. If you set up several, you can more easily switch beneficiaries on one or the other to accomplish those gift and estate tax objectives. And some plans are better than others for different reasons: You may choose to have one in your home state just to capture the full deduction and another in another state to get the best investment choices and lowest costs. Morningstar rates plans on its website ().
- Choose a successor beneficiary. If you own plans in your name but your children are beneficiaries and you die, your plan could go to your kids directly. That could hurt them when it comes time for them to apply for financial aid. Best to make sure your spouse is named in the plan as a successor beneficiary.
- Do it yourself. As with other investments, 529 plans sold through brokers have hidden fees in the form of commissions and higher fund costs. If you do your homework - hey, this is about education, right? - and choose a good low-fee index fund plan sold directly, you'll pay less. Math 101: That can really add up.