Basics of Section 529 Plans: Contributing to a 529 Plan

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Contributing to a 529 plan may seem quite simple — you write the check or get the money automatically withdrawn from your checking account, and those funds get deposited into the 529 plan. That much may be true, but you still need to review the restrictions in this section so that you know who can contribute to 529 plans and how much can be contributed so that you avoid — as much as possible — any complications, such as the tax man.

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.