Basics of Section 529 Plans: Contributing to a 529 Plan

Figuring Out Whether You Can Contribute

Anyone can set up a Section 529 plan (whoever creates an account under Section 529 is considered the plan owner). You don't need to be a parent, grandparent, or even a doting aunt or uncle. You don't need to meet any relationship test. You can even set up a plan and name yourself as the designated beneficiary if you're planning on going back to school.

In fact, the rules regarding who may contribute are so broad that you really need to consider only one major factor before you open a Section 529 plan: Make sure that you have a designated beneficiary (who already must have a Social Security number) in mind and, if he or she's not a sure thing, one or two beneficiaries in reserve. Section 529 wasn't devised to allow you to save money tax-deferred for any other purpose (you have your retirement accounts for that). If, at a later date, your named beneficiary turns out to be a less than sterling student or decides to forgo higher education altogether, you may change your designated beneficiary through a tax-free rollover into a new account or just by changing the name of the designated beneficiary on the account. The new beneficiary, however, must be related to the original one.

Estimating How Much You Can Contribute

In establishing Section 529 of the Internal Revenue Code, Congress and the IRS didn't set express limits on how big these plans could be. They had a tacit understanding that higher educational expenses couldn't be accurately gauged and that annual increases bore no relation to the rate of inflation or any other such economic measurement. If they truly wanted to be responsive to the needs of many to be able to sock enough money away, they knew the plans had to be nonrestricting in their contribution limits but not so open-ended that people could stash fortunes away inside these plans.

The IRS set no specific dollar limits on the amount of money you may contribute into an individual plan, either annually or over the life of the plan. Instead, it limited the amount you could contribute to the amount of qualified expenses your student is going to need for higher education. This is where you'll have to do some guessing. Although there is no dollar limit, if you contribute more than your student will eventually spend on qualified educational expenses, the deferred earnings on any amounts that you contribute over and above will be taxed when you distribute them. The earnings are also subject to an additional 10 percent tax.

Before you consult your crystal ball regarding how much you think you should contribute, you need to take into consideration Gift and Generation-Skipping Transfer Tax issues and individual state contribution limits.

Gift and Generation-Skipping Transfer Tax Considerations

Section 529 plans were devised to allow all people, regardless of their annual income, to save very large sums for higher education expenses. Because there are no annual contribution limits, you may be tempted to sell the family farm and put all that cash into one or more plans. If this sounds reasonable to you, you need to remember that contributions that you make into a plan for any person (other than yourself or your U.S. resident spouse) are subject to the gift and/or Generation-Skipping Transfer Tax (GSTT) rules.

The gift tax regulations include one unique provision, applicable only to Section 529 plans. You may contribute up to five years' worth of annual exclusion gifts ($65,000 in 2009, or 5 x $13,000) in one year. If you're married, your spouse can do the same, enabling you to push $130,000 into a plan for one designated beneficiary in a single year. Should you choose this option, you must file gift tax returns for each one of the five years, claiming your annual exclusion gifts. Furthermore, any additional gifts that you make in the five-year period are then subject to the gift tax or GSTT.

Gift and Generation-Skipping Transfer Tax returns (Form 709) aren't for the weak of heart. Find a professional with expertise in this area (many pros don't have it). Mistakes here are costly, and if they're discovered after the death of the donor (that's you), they're impossible to fix. Don't take that chance!

Contribution Limits Imposed By The States

The federal government doesn't impose any specific dollar limitation on the maximum contribution into Section 529 accounts for a specific beneficiary. But the code section is intentionally vague. And most plans are administered by the individual states: They have far more definite ideas as to the actual dollar amounts necessary to see your children through four years of college.

State-imposed contribution limits vary by state, and the state law that governs your account will be the state in whose plan(s) you are investing, not the state in which you live. Thus, you can invest money in a high-limit state, even if you live in a low-limit state. Also, be aware that states have the ability to change their limits (and often do), increasing them as tuition costs climb.

You really need to shop for plans. Although every state has plans either established or under development, some states limit participation in their plans to state residents, and some states offer a variety of different plans. Some states give you a current income tax deduction or tax credit for contributions into their plan, and some, but not all, follow the federal rules and treat the earned income portion of withdrawals as tax-exempt. The appendix in the back of this book lists state plans at the time of publication. In addition, you can access every plan through its sponsoring state's Web site or through college saving Web sites such as www.savingforcollege.com.

Don't rely totally on Web sites for information regarding a specific plan. If you have any questions or see conflicting information, contact that plan manager, who will have the latest info on the plan in question.

Contribution limits aren't per account, but per designated beneficiary. Your designated beneficiary may have more than one Section 529 plan set aside for his or her use; however, the total aggregate account size in all plans in a particular state can't exceed the limit for the state in which the plan resides. States don't share info, though, so if you begin to bump against the ceiling set by one state, you can open a plan in another state. Just make sure that all the money in all of your plans is used to pay qualifying expenses for your student; the income portion of any excess will be taxed and penalized.