Section 529 plans: Investing for college

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A college education is one of the best investments you can make for your child's future. But the high cost of college may alarm you — especially if you've waited too long to begin planning. For example, a Coverdell Education Savings Account (formerly referred to as an Education IRA), with its annual contribution limit of $2,000, likely won't offer much help if your child is already in high school. And prepaid tuition plans are attractive, but only if your child is willing to attend a school that participates in the plan.
Fortunately, there's another option for your college investment plan. Created in 1996, state-sponsored college investment plans (or Section 529 plans, after the section of the federal tax law that created them) allow flexibility in choosing a school and the opportunity for late starters to make sizable investments while reaping tax breaks.

How the plans work

Section 529 plans allow individuals to invest in a predetermined pool of stock and bond investments. Many plans allow you to invest in a given asset allocation determined by your child's age. In general, the asset allocation will be more aggressive for younger children and less aggressive for children nearing college age.
Lifetime contribution limits to Section 529 plans vary from state to state, but often exceed $200,000, and offer some flexibility on when you can contribute. In addition, there are no income-based restrictions on contribution eligibility and typically no annual contribution limits, although annual contributions of more than $16,000 ($32,000 when made jointly with a spouse) may require filing a federal gift tax return (and in certain cases, could cause you to be subject to federal gift tax). You may contribute five years' worth of gifts all at once, or $80,000 per beneficiary ($160,000 in the case of joint contributions with a spouse), without triggering the federal gift tax. All earnings in the account grow tax free, assuming distributions are used for qualified higher education expenses. If you live in the state where the plan is administered, you also may be eligible for state tax deductions. Please consult with your tax professional concerning your situation and potential tax consequences to you.
Once your child reaches college age, the account owner may withdraw money from the account to pay for qualified higher education expenses. Assuming that you have followed the plan's rules, there will be no additional tax (although nonqualified withdrawals will be subject to a 10% additional federal tax, unless a specified exception applies, in addition to ordinary income taxes). And qualified withdrawals — that is, distributions used to pay for qualified higher education expenses — are federal (and possibly state) income tax free. If there is money left over in the account, the beneficiary designation can be changed to a sibling, first cousin, or other family member (as defined by the Internal Revenue Code) of the original beneficiary without triggering gift taxes.

Pros and cons

Flexibility in contributions and college choice is the biggest advantage of Section 529 plans over other tax-advantaged education savings vehicles. Even though these plans are state-sponsored, you do not need to be a resident of the state to participate, although you may lose out on state tax benefits by participating in an out-of-state plan.
Apart from potential tax savings, these plans offer the advantage of professional asset management. Each state contracts with a single asset management firm to oversee the plan, so by comparing various state plans, you'll be able to choose from several professional management companies. For more information on each state's plan, visit This website includes graphical ratings that compare the plans and links with plans that have websites.
The primary drawback to Section 529 plans is investment risk. Unlike state-sponsored prepaid tuition plans, returns from Section 529 plans are not guaranteed. This means that your investment could lose value, perhaps just as your child is beginning college. Although the firms that manage Section 529 plans typically use less-risky asset allocations to reduce risk as your child nears college, if you're using an age-based portfolio, risk cannot be eliminated altogether.
You'll also want to have a thorough understanding of contribution and withdrawal rules before investing in a plan, since rules vary depending on the state. Pay particular attention to rules regarding transfers, early withdrawals, or withdrawals for things other than certain college expenses. Ordinary applicable federal and state income tax and a 10% additional federal tax are imposed if withdrawals are not used for qualified higher education expenses (although the 10% additional tax will not apply if a specified exception applies).

Choosing the plan that's best for your family

Section 529 plans are just one of the options you have for college investing. They offer a great deal of flexibility in exchange for a higher level of investment risk. If you're getting a late start or if your child is unsure of which college he or she wishes to attend, a Section 529 plan may be your best choice.
But if you're starting early on saving for college, you might consider a prepaid tuition plan. This plan allows you to lock in today's tuition rate, which can mean a savings of thousands of dollars in college costs. Prepaid tuition plans guarantee payment of a semester's tuition for each unit that you buy, and payments may be spread out over several years. Almost all prepaid tuition plans are more restrictive when it comes to choosing a college, and they may also be more restrictive in terms of withdrawals. Applicants will typically receive a list of participating colleges that a child can attend. If the child wishes to go to a school outside the plan, the value of the investment may be reduced.
Coverdell Education Savings Accounts (formerly called Education IRAs) allow you to set aside money each year toward a child's education. The annual contribution limit is $2,000 per child. Withdrawals for qualified education expenses are federal (and possibly state) income tax free, and account balances can be transferred to siblings without any tax consequences so long as it is done prior to the previous beneficiary's 30th birthday and the new beneficiary is under the age of 30. While tax benefits make these accounts attractive, the low contribution limit may not provide enough money to pay for college. Unlike state-sponsored plans, income limits apply to a contributor in determining eligibility. Only single filers (including married filing separately) with modified adjusted gross income ("MAGI") of less than $110,000 and joint filers with MAGI of less than $220,000 are eligible to contribute.
As with any financial planning decision, the choice that's best for you will depend on your unique situation, including your risk tolerance and the number of years until your child begins college. Another consideration is your child's plan. Does he or she even plan on attending college? If so, has he or she chosen a school? Talk with your child about college before finding the plan that best suits your needs.

Please remember there is always the potential of losing money when you invest in securities.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Asset allocation or diversification does not ensure a profit or protect against loss in declining markets.

Before you invest in a Section 529 plan, request the plan's official statement from a Merrill Financial Professional and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the 529 plan, which you should consider carefully before investing. You should also consider whether your home state or your designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds and protection against creditors that are available only for investments in such state's 529 plan. Section 529 plans are not guaranteed by any state or federal agency.

  • Subject to applicable limits, the gift-tax exclusion may apply to contributions to a Section 529 plan. Contributions between $16,000 and $80,000 ($32,000 and $160,000 for married couples filing jointly) made in one year can be prorated over a five-year period without subjecting you to gift tax or reducing your federal unified estate and gift tax credit. If you contribute less than the $80,000 ($160,000 for married couples filing jointly) maximum, additional contributions can be made without you being subject to federal gift tax, up to a prorated level of $16,000 ($32,000 for married couples filing jointly) per year. Gift taxation may result if a contribution exceeds the available annual gift tax exclusion amount remaining for a given beneficiary in the year of contribution. For contributions between $16,000 and $80,000 ($32,000 and $160,000 for married couples filing jointly) made in one year, if the account owner dies before the end of the five-year period, a prorated portion of the contribution may be included in his or her estate for estate tax purposes. Please consult your tax and/or legal professional for such guidance.
  • To be eligible for favorable tax treatment afforded to any earnings portion of withdrawals from Section 529 accounts, such withdrawals must be used for "qualified higher education expenses," and withdrawals from Coverdell ESAs must be used for "qualified higher education expenses or qualified elementary and secondary education expenses," as defined in the Internal Revenue Code. Any earnings withdrawn that are not used for such expenses are subject to federal income tax and may be subject to a 10% additional federal tax (unless an exception applies), as well as any applicable state and local income taxes.
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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

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