Qualified State Tuition Programs

Qualified state tuition programs, most commonly referred to as Section 529 plans because that's the section of the United States Code that governs them, are one type of investment account for college. How do they work? Individual states sponsor investment savings plans where you put money into the state's program and that program pools your contributions with others and invests them in various investment vehicles for you. This type of program works a lot like a mutual fund where a professional of some sort, usually an investment advisor, manages your account.

At this point you're probably thinking, sounds pretty good for the state. The state gets to use my money for investments, why can't I do this on my own? There's nothing to stop you from investing on your own for education payment purposes, but the big drawing card for using state-sponsored plans is that the funds you invest plus their earnings can be withdrawn tax-free as long as they are used for qualified education expenses. Since that's a pretty big selling point, you may want to read on for an overview of these types of savings plans.

Because every state has a different plan available, an excellent reference to consult is the College Savings Plans Network website. This site gives you a great overview of the college savings plans and provides a state map that takes you to information about what each state offers, as well as their websites, phone numbers and addresses.

Basic characteristics. That being said, while each state's investment savings plan may have some differences among one another, most characteristics are pretty much the same no matter which state you choose. First of all, anyone can contribute to a state-sponsored education plan. This includes parents, grandparents, distant relatives, and friends of the beneficiary. Often, it doesn't matter if the contributor or beneficiary is a resident of the state you choose. There's no limit imposed on contributors based on their income level, which frees those who would be more likely to be able to contribute to do so. And those contributions can be substantial, although contribution amounts vary, subject to restrictions. Again, while the contributions themselves are not deductible, the amounts earned by the funds invested in the plan grow tax-free and the original investment and earnings are tax-free when withdrawn if they're used for qualified education expenses.

Qualified education expenses. What are qualified education expenses? Surprisingly, it's a standard that's pretty simple to meet. Section 529 Education Plans are tax-advantaged savings plans that cover all qualified education expenses, including: tuition, room & board, mandatory fees and books. Economic recovery legislation provides that computers and computer technology may be allowed as qualified education expenses. Again, we strongly urge you to check with your state for its specific rules.

Tip Private colleges that meet certain requirements are allowed to sponsor savings plans similar to the ones sponsored by states. Since 2004, qualifying distributions from these plans are tax-free.

What if your child doesn't go to college? OK, you're probably at the point where this is sounding pretty good, but there's that one nagging worry. What if you set up a qualified state tuition plan for your children or grandchildren and they don't go to college? Or suppose one of them wins the lottery and doesn't need your pittance to pay for their education? Well with state savings plans, you have a choice of cashing in the plan and paying tax and a penalty on the earnings, or naming a different beneficiary. If you name a new beneficiary, you won't have to pay taxes (which would be at your tax rate by the way) on the principal and earnings transferred. Can you pick anyone to be the new beneficiary? The answer is no, you now have to limit your choice to a relative of the beneficiary you're replacing. By relative we mean a parent, child, sibling, cousin, aunt or uncle of the beneficiary you're removing.

Example Jack and Jill have two children, James and Stewart. Jack's brother, Jerry, and his wife, Elaine, also have two children, Spencer and Tracy. Both Jill and Elaine contributed large amounts to their respective children's state-sponsored college plans and James, Stewart, Spencer and Tracy are each the named beneficiaries of substantial accounts. Stewart is the oldest and has already made it clear he intends to go on the comedy club circuit and follow in the steps of his famous comedian uncle Jerry. In return for Jerry taking Stewart under his wing and using his influence to help Stewart's career, Jack and Jill replace Stewart as the beneficiary of his account with Jerry and Elaine's daughter, Tracy. Because Tracy is Stewart's cousin, there is no tax due on the principal or earnings in the plan originally set up with Stewart as the beneficiary.

Changing your plan to a different state. On a final note, please note that you can also change the plan you are contributing to from one state to a different state and keep the same beneficiary. For example, say after contributing to one state's plan for your nephew for two years you find that a different state has a better track record with their investments as well as other features that you prefer. You should be able to transfer the account to the other state while keeping your nephew as the beneficiary. Again, this avoids the nasty tax implications of closing out an account. Generally, the only limitation on this type of change is that it can only be done once every 12 months.

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