Employee Benefits Bulletin, September 2002
529 College Savings Plans
a Must-Have employee Benefit in Alabama?
Promotional information on 529 College Savings Plans ("529 Savings Plans") is everywhere. Although they are not new, changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") breathed new life into this vehicle for college savings. More and more, these plans are being marketed as a valuable employee benefit that employers may offer their employees.
What is a 529 Savings Plan?
A 529 Savings Plan is governed by Section 529 of the Internal Revenue Code ("Code"). It is a state-sponsored college savings program that allows individuals to accumulate tax-advantaged savings for financing a beneficiary's college expenses. Almost every state now sponsors some type of 529 Savings Plan, and most of these plans are open to both residents and nonresidents (although nonresident participants might be subject to higher plan fees).
Before EGTRRA, individuals contributed after-tax money to a 529 Savings Plan account. Those funds would enjoy tax-free growth until distribution, at which time the earnings were taxed at the beneficiary's tax rate. After EGTRRA, the 529 Savings Plans work much like a Roth IRA: earnings on the after-tax contributions are income tax-free, even at distribution, as long as the distribution is used by the beneficiary for qualified education expenses.
What are the major characteristics of a 529 Savings Plan? Are contributions tax deductible?
Contributions are not deductible when computing federal income tax. However, some state laws provide a deduction for state income tax purposes for contributions to in-state 529 plans. For example, Georgia's plan allows a state tax deduction for contributions up to $2,000 per dependent beneficiary for contributors with an adjusted gross income below a certain amount. Alabama's plan does not provide any type of deduction.
Are earnings tax-deferred?
Yes. All interest and dividends earned on contributions are not subject to income tax, as long as they remain in the 529 Savings Plan account.
Are distributions tax-free?
Yes, for federal income tax purposes, as long as withdrawals are used for qualified education expenses (college and graduate school tuition, room and board, books, fees, supplies, and equipment). Nonqualified withdrawals are subject to a 10% penalty tax, in addition to the contributor's income tax rate.
The story is different for state income tax purposes-tax treatment of distributions varies from state to state. For example, distributions from Alabama's 529 Savings Plan are still subject to state income tax. Likewise, withdrawals from another state's 529 Savings Plan by an Alabama taxpayer are also subject to Alabama's income tax. On the other hand, Georgia statutes exempt its taxpayers from paying state income tax on withdrawals from Georgia 529 Savings Plan accounts open longer than one year. Additionally, qualified withdrawals from other states' 529 Savings Plans are also exempt from Georgia income tax.
Is eligibility based on income?
No. Anyone, regardless of adjusted gross income level or relationship to the beneficiary, may make contributions. Parents, grandparents, distant relatives, friends, and even the beneficiary may put money in the 529 account.
Are there any contribution limits?
Yes and no. 529 Savings Plans are subject to aggregate contribution limits established by each state. For example, Alabama's plan will accept contributions until all 529 accounts in the state for a particular beneficiary total $269,000. There are no annual contribution limits for any 529 Savings Plan, although individual contributions are usually guided by gift tax laws. Federal gift tax law allows an annual exemption of $11,000 per person per year. Special 529 rules allow a contributor to consolidate 5 years worth of gift tax exclusion into one year's contribution. Thus, a couple could donate $110,000 in one year to a single beneficiary without any gift tax consequences ($11,000 per year x 5 years x 2 individual donors). Obviously, a large, early lump sum contribution to a 529 Savings Plan account maximizes compounded growth. However, if your state's plan allows for a state income tax deduction for contributions to its 529 plan, and the deduction is subject to an annual limit, smaller sums contributed over several years might produce greater tax savings compared with a large one-time contribution.
Does the donor control the disposition of the account?
Yes. The account owner (donor) retains control over the disposition of the account, regardless of the age of the beneficiary. (Compare with UTMA and UGMA accounts on page 3.)
How are the funds invested?
Once again, the answer varies from state to state. Section 529 of the Code prohibits the account owner or beneficiary from directly investing the contributions. However, most, if not all, states have selected a major mutual fund company or 401(k) provider to manage their 529 Savings Plans, and the plan structures provide a limited choice of investment direction for contributors. The plans usually offer aggressive, moderate, and conservative fixed portfolios, as well as an evolving, age-based option that becomes less aggressive as the beneficiary approaches college age. Donors select an investment option for each contribution made to the 529 account, but after that original direction, funds may be reallocated only once a year.
What makes a 529 Savings Plan different from other college savings strategies?
The best way to understand the 529 Savings Plans and their differences from the other education savings opportunities is to briefly discuss the differing strategies:
1. Prepaid Tuition Programs
Prepaid tuition programs also fall within the scope of Section 529 of the Code, but they differ significantly from the savings plan accounts discussed above. Through state-sponsored prepaid tuition programs, parents may lock-in a set amount for up to four years of tuition for their child at a college or university defined by that state (normally in-state public schools). Contributors (they may be anyone, regardless of income or relationship to the beneficiary) then pay the set amount in a lump sum or in monthly installments. Contributions are not tax-deductible, but they enjoy tax-free growth like the 529 Savings Plans. The prepaid tuition programs do not have the market risk of the 529 Savings Plans, however, they also lack the 529 Savings Plans' freedom to use the money for any accredited public or private college, trade, or graduate school education nationwide. Prepaid plans differ as to what happens to the money if the child goes to a non-approved school.
2. Coverdell Education Savings Accounts (Education IRAs)
The nondeductible contributions to Coverdells, like 529s, enjoy tax-free growth and are exempt from federal taxes upon withdrawal if used for qualified education expenses. The largest advantage of the Coverdell is that you can use them to pay for any level of accredited education, even kindergarten. However, Coverdells limit annual contributions to a very small amount-only $2,000. Additionally, the ability to make contributions phases out for individuals at certain levels of adjusted gross income.
3. Uniform Gift to Minors Act (UGMA)/Uniform Transfer to Minors Act (UTMA) Accounts
A major benefit to saving through UGMA or UTMA accounts is that, unlike 529 plans, the parent has complete control over how the portfolio is invested. On the flip side, the biggest disadvantage of the UGMA or UTMA accounts is eventual loss of control over the money itself. In fact, when the beneficiary reaches the age of majority (18 to 21, depending on the state), he or she has complete control over the funds. An UGMA or UTMA account also does not have the rich tax benefits that a 529 does. Only a portion of the earnings accrues tax-free; the remainder is taxed at the child's rate, (if the child is over age 14). The tax treatment is even more harsh if the child is under age 14.
Should Employers Offer 529 Savings Accounts as an Employee Benefit?
Many states' plans have the ability to accept payroll deductions or direct deposits, so the managing companies have been marketing the 529 Savings Plans to employers. The vendors say there is little cost or administrative effort involved for a company to make the 529 plans accessible to employees. This is true. Employers do not have to contribute to the plans, and, because the 529 plans are not subject to ERISA, it is not necessary to maintain plan documents or test for nondiscrimination. However, there are a few downsides to consider, including the fact that the recent change making the plans so popular might disappear in less than ten years. Unless Congress decides to make the 529 portion of EGTRRA permanent, the sunset provision of EGTRRA will kick in at the end of 2010, and the law will revert back to pre-2001 rules. This would mean that 529 Savings Plan withdrawals after 2010 might again be subject to federal income tax at the beneficiary's rate. Another consideration for employers is whether implementation of a 529 Savings Plan would hurt rank and file employee 401(k) contributions (bad for 401(k) nondiscrimination testing). Finally, Alabama employers might want to adopt a wait-and-see approach. Alabama's 529 Savings Plan is managed by Van Kampen Investments and does not yet accept any type of payroll deductions. Of course, an Alabama employer is free to participate in another state's plan, but maximum savings for employees will only come if the Alabama Legislature decides to make contributions state tax deductible and withdrawals state income tax free.
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