Tax Article -Permanent Tax-Exempt Status Gives a Huge Boost to 529College-Savings Plan

Included in the Pension Protection Act signed by President Bush in August was a provision to give permanent tax-exempt status to the 529 college savings plans.  This is a significant development for plans intended to help pay for the ever-escalating cost of a college education.

The 529 plans many people invest in now weren’t always so tax-friendly.  Before 2002, if you invested in a 529, earnings grew tax-deferred and when the money was withdrawn it was taxed at a child’s rate.  But thanks to another law passed in 2001 and which took effect in 2002, state-sponsored 529 plans gained federal tax-exempt status.  The change allowed contributions to grow tax-free and earnings became sheltered from federal taxes as long as the money is used to pay for qualified higher education expenses.  This favorable tax treatment was scheduled to expire Dec. 21, 2010.  If it had expired, the tax benefit would have returned to what it was before 2002. 

Before the tax-free benefit, states and financial advisors were having a tough time selling this investment vehicle.  By 2001, $5.77 billion had been invested in 529 plans across the country.  Since the change in the tax status of these accounts, an additional $74.4 billion has been added, according to Chris Hunter, program manger at the College Savings Plan Network.  In an online poll taken by Joseph Hurley, founder and chief executive of SavingforCollege.com, 51% of respondents said they would put more money into 529 plans if the tax-exempt treatment was made permanent.

“I believe that making the 529 tax status permanent is the single most important development affecting college savings since the 2001 tax act first gave us tax exemption,” Hurley said.

Every state and the District of Columbia now offer at least one 529 plan.  The College Savings Plan Network (www.collegesavings.org) provides links to each state’s 529 plan website with nuggets of details about what plans each state offers. You can invest in any plan regardless of where you live. The money invested in a 529 plan can be used for a state or private institution.

Like any investment, there’s much to know about these plans so invest with caution.  For instance, watch out for fees.  College savings plans are sold to investors either directly by the state-sponsored plan or via an investment advisor, brokerage firm, or bank.  Broker- and advisor-sold plans often contain sales loads and higher fees and expenses than direct-sold plans, according to NASD, the private-sector regulator of the securities industry.

NASD has an excellent section on its website about investing for college, including a tool that helps you compare fees and expenses.  Go to www.nasd.com and click the link for Investor Information.  Then click the link for College Savings Center and then Expense Analyzer.

NASD’s analyzer requires some work because you have to input fee and expense information.  If you don’t have time to hunt through 529 brochures or disclosure statements then use Hurley’s 529 Evaluator at www.savingforcollege.com.  You can compare up to six plans at a time side by side, and the expense and fee information is provided.

There is something else to consider before investing in a 529 plan.  Check to see whether your home state offers a tax break.  For example, if you are a Connecticut resident and you invest in the state’s 529 plan, you can get a state income tax deduction of up to $5,000 ($10,00 for married couples filing jointly).

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