When planning to save for future college expenses, you may run across several options – including insurance policies, savings bonds, retirement accounts and specific education accounts, such as Coverdell Education Savings and Section 529 plans.
Among the options for Section 529 plans are two types of account: savings and prepaid tuition. Following is a brief explanation of the two types of account.
Savings-Type 529 Plan
The savings type of 529 plan works much like an IRA or 401(k): contributions are made and the amounts contributed to the plan are allocated among various sorts of investment options, mostly mutual funds or derivatives of mutual funds. Over time, assuming that you’ve made appropriate allocation choices and the investments grow, the balance of the account will in turn grow, increasing the amount of funds available to pay for college expenses. Growth in the account is tax-free when used for qualified higher education expenses (QHEE).
As with any investing activity there are risks to investing in these plans – similar to the risks you face in your IRA or 401(k) plan. It’s possible that your account could lose value at any given point in time (like late 2008, for example) but prudent investment choices, appropriate time-orientation, and risk management can help to assure that your account will grow over time – but there are no guarantees.
Prepaid Tuition 529 Plan
On the other hand, the prepaid tuition type of plan is set up quite differently from any other type of account. Instead of a savings account, in this case you’re purchasing discounted “units” or semesters of education – which, backed by the sponsoring state, are guaranteed to be traded for equivalent semesters of public college education (in the sponsoring state) when the student reaches college age.
If the student chooses to attend a non-public school or a school in another state, the programs guarantee that the equivalent of the then-current tuition cost will be available to pay the college of choice, even though the cost at that school will be different from the state universities in the sponsoring state.
Just as with the savings-type of plan, growth in the account is tax-free if used for QHEE – and in either type of plan if you choose not to use the account proceeds for education, you can withdraw the value and pay tax and a penalty on the growth.
The Downside to Prepaid Tuition
So, with all the market volatility, you’d think that the prepaid plan is the way to go – after all, this type is guaranteed! Unfortunately, that guarantee by the sponsoring state is only as good as the state’s finances; these days, for many states, finances are currently listed under the heading of “Deplorable”. When you couple the finances of the state with the dramatic increases in tuition costs we’ve seen in recent years, someone is bound to take a hit. Guess who “someone” is?
Many prepaid tuition plans were forced to bar adding new participants to their plans after the dot-com bubble burst several years ago, since poor market returns and higher tuition rates were causing the plans to lose money far too quickly to make up reserve balances. Now, similar situations abound, and the states backing the plans may or may not have the funds to help shore things up. As a result, new fees have sprouted for many plans – along with large increases in the discounted costs for new credits being purchased, which chokes off the new money coming into the plans.
According to a recent article in the Wall Street Journal, all across the nation prepaid tuition plans are operating in the red – seems that the market volatility does have an impact on these plans after all, just a little more subtle and after the fact. And it’s up to the state to determine if their promises are worth keeping… and here in Illinois we don’t have that much faith in our state government. Your mileage may vary.
For my money, it just makes far more sense to use the savings-type of 529 plan: a plan that you can understand, can follow the balance, and perceive how and why fluctuations occur. With those plans, you know what you have in the account, day in and day out. With the prepaid plans, especially given the poor fiscal conditions of the states guaranteeing things, it’s all in question, in my opinion.
Photo by Medmoiselle T
The start of a new year often signals a time for change–especially when it comes to taxes, and 2010 has brought some major changes. As of January 1, the federal estate and generation-skipping transfer (GST) taxes are repealed, and the step-up in basis rule is modified for 2010. While it’s possible (and some believe very likely) that Congress will reinstate these taxes, until that time, it’s important to understand these significant federal tax law changes and how they might affect you.
It’s possible Congress may reinstate the estate tax retroactively, that is, back to January 1, 2010, in which case heirs who already received their inheritance may have to reimburse the estate to enable it to pay the reinstituted estate tax. On the other hand, heirs who haven’t received their inheritance may have to wait for their gifts until the likely challenges to the constitutionality of instituting the estate tax retroactively have been resolved in the courts. In any case, until these issues have been cleared up, it may be wise for executors and trustees of estates in 2010 to retain sufficient assets in the estate to pay a potential estate tax.
The generation-skipping transfer tax is a federal tax on transfers of property made, either during life or at death, to an individual who is more than one generation below you, such as your grandchild. The tax, also repealed for 2010, had a $3.5 million exemption in 2009 and a top tax rate of 45%. However, like the estate tax, the GST tax is also scheduled to be reintroduced in 2011, with a $1 million exemption and top tax rate of 55%.
In addition, heirs who want to sell inherited assets not covered by the step-up in basis will have to try to figure out the decedent’s cost basis in order to calculate potential capital gain. For example, assume you inherit shares of XYZ Company stock in 2010. You sell them and now have to determine whether you owe a capital gains tax. First, you need to know if any of the $1.3 million step-up in basis applies to these shares. If your XYZ stock didn’t receive a basis step-up, you’ll have to figure out the cost basis of your inherited stock. Arriving at the cost basis of inherited property may prove difficult, if not impossible, especially if the decedent didn’t keep accurate purchase records, or if the stock split over the years, or if the decedent received some of the stock by gift or inheritance.
Another potential issue surrounds the constitutionality of Congress reinstating the estate tax and/or GST tax retroactive to January 1, 2010. Congress has imposed taxes retroactively in the past and when challenged, taxpayers have lost the majority of the time. Whether Congressional reinstatement retroactive to January 1 will withstand a challenge is conjecture at this point since Congress has yet to act, but the possibility of reinstatement of either or both taxes further adds to the estate planning conundrum in 2010.
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