Advising Your Clients on Section 529 College Savings Plans, with Joe Hurley

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Session Moderator: Welcome everyone and thank you all for coming today.

Joseph F. Hurley, CPA is a certified public accountant with over 20 years of experience in providing tax-planning services to individuals, corporations, and tax-exempt organizations. As a partner at Bonadio & Co., LLP, a 100-person CPA firm headquartered in Pittsford, New York, Joe has had overall responsibility for the firm's delivery of tax services to its clients.

With the support of his firm, Joe founded LLC in May 2000. Joe is the author of: "The Best Way to Save for College - A Complete Guide to Section 529 Plans"

Today we welcome Joe in a discussion about all the ins and outs of Section 529 plans.

It's all yours Joe!

Joe Hurley: Thank you. Welcome to our workshop on Section 529 college savings plans, the "hottest" college investment in the country. As we go through this I hope you will feel free to ask questions. I'm not sure how this will work but if the moderator let's me answer the questions, and they are appropriate to the topic, I will respond immediately. Otherwise, I suppose questions will be left for the end. But again, feel free to ask, whether they are general questions about 529 plans or questions about a specific state plan.

Session Moderator: You can answer questions throughout the workshop, and everyone is welcome to make comments and ask questions at any time

Joe Hurley: First, a little background. I first "discovered" 529 plans in 1997 when New York enacted a law for one. I jumped on it, wanting to be the foremost expert among Rochester New York CPAs. I was fascinated not only by the benefits for families saving for college, but also by the fact that states were getting into the business of investing other peoples' money. Talk about reverse-privatization!

Well, anyway, when I discovered that no one else in the country seemed too interested in being the "expert" on 529 plans, I decided to commit myself to writing a book and starting a web site. I also decided to go to Washington and present comments on newly proposed regulations.

Now I get to be called the "expert" not just among Rochester CPAs but across the country. It's led to interviews by all the major financial publications, radio, and television. I started a new company called LLC that markets my book "The Best Way to Save for College - A Complete Guide to Section 529 Plans", my newsletter for professionals called "The 529 Plan Report", and a directory for financial planners and investment advisors. I also do a lot of consulting and speaking. It now takes close to 100% of my time.

Enough about me. On to section 529.

IRC section 529 describes qualified state tuition programs, or QSTPs for short. I refer to them as 529 plans because I have a hard time pronouncing "cuestip" and a hard time typing capital letters. They are state-sponsored investment programs for families saving for college. The state program must meet the requirements of sec. 529 to be a 529 plan. The basic idea is that you set up an account with the state, name a beneficiary of the account, give them your dollars, and then your money is invested to be withdrawn when your child begins college. There are 42 states now with 529 plans, and six other states have them in development. Two states, Georgia and South Dakota, do not have them.

There are two general types of 529 plans that the states have. One kind is a "prepaid tuition plan," that works much like a tuition futures contract. You buy future tuition at an in-state public institution now. The other kind is the "college savings plan" which works more like a mutual fund or an IRA. The growth of your account depends on the underlying investments used by the state. It has upside (and downside) investment potential.

The interesting thing about the savings plans is that many of the states have opened them to nonresidents. I'm living proof of this - I have accounts for our two kids in 19 different states right now.

The advantages for investors in a 529 plan include the following:

1. The account grows tax-free until withdrawn.
2. When withdrawn to pay for college, the earnings portion of the withdrawal is taxed to the beneficiary, presumably a student in a low tax bracket.
3. The account owner stays in control of the account so the beneficiary doesn't have any rights to the money.
4. Anyone can use 529 plans. There are no income limits or age limits in the law. You can even set one up for yourself. And the dollar amounts you can put in are fairly substantial, up to $170,000 in some states.

A lot of people have money in the kids' names to take advantage of low tax brackets (UGMA or UTMA accounts) but then have to worry about the child using the money for other purposes when they reach age 21 or 18. So the control aspect of the 529 plan can be very appealing as an alternative to an UGMA.

Probably the most interesting area is in the gift and estate tax treatment of 529 plans. Despite retaining control, sec 529 says that the contribution into a 529 plan is treated as a completed gift that qualifies for the $10,000 annual gift exclusion. In essence, it's a revocable gift that gets removed from your estate.

There is also a special election you can make on Form 709 to treat a contribution of more than $10,000 as made over a five-year period. This means as much as $50,000 can be contributed immediately for one beneficiary without gift tax. A couple of grandparents doing estate planning could quickly dump $100,000 per grandchild into a 529 plan, easily and effectively. Now the donor has to live for five years to get the full benefit. Otherwise the "unearned" portion is included in the estate of the donor.

Now while you have time to absorb all that, I would like to get a sense of the states that you live in because it helps to know where you are coming from. Please type in your state.

Sharvey: Illinois.

Claude Titche: Michigan

Susan Stutzman: Pennsylvania

Session Moderator: Indiana

Kim Adney: Washington; but interested in Iowa residency applications also.

Joe Hurley: Ok we have a pretty good mix of savings plans and prepaid plans.

Session Moderator: What happens if there is more in the fund than the beneficiary needs for college costs?

Joe Hurley: Withdrawals from the 529 plan are either qualified (used for college) or nonqualified. The nonqualified distributions have to be subject to a penalty. Under the current proposed regs, the minimum penalty is 10% of the earnings portion of the distribution. So you can see that if the account ends up being overfunded, and you want to take out the excess, you will get 100% of the principal and 90 % of the earnings. That's not too bad, actually. If the overfunding is due to receipt of a scholarship or tuition waiver, then there is no penalty on taking it out.

Kim Adney: Does the definition of "Qualified" withdrawals include other costs besides tuition?

Joe Hurley: 529 plans can cover more than tuition. They also cover supplies, equipment, and room and board (which is the expensive part).

Claude Titche: Would it be possible to transfer the "extra" funds to another child?

Joe Hurley: You also have the option to change the beneficiary on the account to someone else who can use it.

Session Moderator: Are the earnings of a 529 plan, when withdrawn, taxed at ordinary rates or capital gain rates?

Michael Tandy: Ordinary

Joe Hurley: The earnings are taxed as ordinary income when they come out. Most students are in the 15% tax bracket. But they cannot use the lower 10% capital gains bracket. I think a lot of people try to compare the after-tax results from a 529 plan with other options such as stocks and mutual funds.

We have done projections to show that the tax deferral feature and shifting to the kid's bracket is usually better than parents holding investments in their own name and taking capital gains. Even if you are willing to put the money in a taxable UGMA account, a 529 plan could turn out to be better after-tax. It depends on the mix of investments.

Speaking of investments, you will see a wide variety of investment options among the different state plans. But also note that IRC 529 contains a ridiculous rule that says you cannot have control over your investment once your dollars are in the account. This means that you need to be comfortable with how the state is investing the accounts.

Session Moderator: However, it is my understanding that you can invest in a plan in other states - not just your home state - so you can shop around, right?

Joe Hurley: I always suggest checking out your home state plan first. Get an understanding of it. Find out if there are any tax benefits with the in-state plan. But then, yes, shop around.

Many states with savings plans have now gone out to investment companies to manage the programs. The players include Fidelity, Merrill Lynch, TIAA-CREF, American Century, Strong, State Street Global, Putnam, and now Morgan Stanley Dean Witter. The 529 marketplace is becoming quite competitive with all the new investment companies involved. They see a very large potential market.

Right now, total assets in 529 plans are under $10 billion, and most of that is in the prepaid plans. But the assets should start multiplying.

Claude Titche: Currently, would you recommend a state as a better investment?

Joe Hurley: I rate the state from one to five "caps" at But I look at much more than the investments. The plans vary tremendously in their features and so you need to watch out for the traps. Some states will give you attractive fixed income investments. For example, in Utah I am getting around 6 % on a fixed income fund, and then they take on the earnings from a separate endowment fund, so it ends up being closer to 8%.

You can also find much more aggressive options. Several states now have all equity funds. These include many of the states using the investment companies I mentioned above. And you can find index funds in states like Utah and Indiana.

The other program that many states have is an age-based program that starts out aggressive when the child is young and then gets more conservative as the child ages. This has a certain appeal considering that many families do not want to be too aggressive shortly before college bills come due.

Another area to think about is the expense involved in any of the state programs. I think that for the most part the expenses are very reasonable considering what it takes to run a program. They will range anywhere from around 30 basis points to as much as 170 basis points. This includes the underlying costs of mutual funds used by the programs.

Let me tell you how I think these plans can help in your practice.

Steve Klane: How does the New Hampshire Fund run by Fidelity compare with other programs?

Joe Hurley: New Hampshire is a pretty basic age-based program.

Fidelity does a nice job with their 529 plans. The cost is around 1% per year plus fees if your balance isn't high enough. What's interesting is that a second program will be coming out using the Fidelity Advisor funds. This is a part of a trend that sees more plans using brokers to distribute them. So brokers who a year ago were saying "stay away from 529" are now saying "I can help you with that". If you are doing investments in your firm, this is certainly something to think about. If you are not, you can still be very helpful in working with your clients.

It's in the estate planning area that you can get the most mileage. Your wealthier clients may not be doing gifting currently because they can't stand the thought of giving away their assets irrevocably. So you suggest, here is a way to get the money out of your estate and not give away any control. As the account owner, you can always ask for it back.

Many grandparents like the idea of funding their grandkids education this way, and they are not so hung up about comparing investment performance from one state to another. So now a couple of grandparents can plunk $100,000 per grandchild into 529 plans. It's easy. There are no trusts, no partnership agreements, in other words, not a lot of legal fees to set it up. Some grandparents ask what happens to their account if they die. Many of the states allow you to name a successor owner on the application form. This makes it easy. In fact, in some states you can transfer ownership while living. This is also helpful to grandparents who think they may want to dump the responsibility onto their own kids in the future.

Financial aid is another consideration. The 529 plans are considered an asset of the account owner, not the student. So this makes is favorable from the financial aid standpoint. Prepaid tuition plans are different though and can reduce aid eligibility on a dollar for dollar basis.

Has anyone had good or bad experience in setting up 529 accounts?

Remember that you can use these for graduate school too. Although one state may have a maximum contribution limit, of say, $150,000, if you expect a kid to go to a private college, then medical school, then business school, there is not reason not to think you can put in more than $200,000 by spreading it between states.

Another option is the education IRA. $500 per child per year. Ha ha. But keep your eye on the education IRA. I get the feeling that Washington really wants to make these better and more competitive.

Steve Klane: What happens when the accumulated account balance is greater than the expenses?

Joe Hurley: Steve, you can roll it to another beneficiary, take a nonqualified distribution (10% of earnings penalty) or just keep it there until the great great grandchildren can use it.

Steve Klane: So the balance is exempt from generating skipping tax?

Joe Hurley: The $10,000 annual exclusion works for the GST too, so that shouldn't be an issue.

Steve Klane: Generation Skipping Tax. Thank you.

Joe Hurley: I'd like to thank you all for attending. Any last question before you go off to visit

Session Moderator: Thanks, Joe for an extremely informative workshop! Thank you all for attending.

Workshop sponsored by:

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