Morningstar Advisor - Summer 2008 - (Page 45)

Spotlight 10 Tax-Smart Tips for College-Savings Planning By Susan T. Bart Section 529 savings accounts need to be handled with care; otherwise, their tax benefits could turn into tax nightmares. Here are 10 strategies to help your clients keep their college-savings accounts running tax-efficiently. 1. Fund Conservatively When using a 529 plan account as a vehicle for college savings, don’t overfund it. Your client risks having to take a nonqualified distribution if the account has more money than is necessary to pay the beneficiary’s qualified higher education expenses (and if there is no family member of the beneficiary with a need for higher education funds whom your client would like to designate as a new beneficiary). The earnings portion of a nonqualified distribution will be subject to income tax at the recipient’s tax rate. The earnings are taxed as ordinary income, whether they came from interest, capital gains, or dividends. In addition, the earnings will be subject to an additional 10% tax (unless the distribution was made because of the beneficiary’s receipt of a scholarship, disability, or death). If you’re thinking that deferring income tax in a 529 plan could offset the higher tax rates and the tax penalty that come with a nonqualified distribution, think again. Under current tax laws, a portfolio of 100% equities wouldn’t offset the taxes on a nonqualified distribution even over a period as long as 30 years, according to Monte Carlo simulations prepared for me. If there are excess funds in a beneficiary’s 529 savings account, the account owner can change the beneficiary to an individual who is a “member of the family” of the old beneficiary without income tax consequences (see Tip 9). Thus, if the donor is funding the education of several beneficiaries, such as all of the donor’s children, any excess in one of the accounts could be applied toward the education of another child whose qualified higher education expenses exceed the amount in his or her own 529 account. You still need to plan, however, to ensure that the total amount of all of the children’s accounts does not exceed the total amount of their qualified higher education expenses. Although the donor could at the completion of the children’s educations change the beneficiary of any remaining 529 funds to a grandchild, a change of beneficiary to a lower generation will have gift-tax consequences that should be considered (see Tip 9). To guard against a conservatively funded 529 savings account falling short of meeting qualified expenses, it’s smart to use supplemental gift and savings vehicles in tandem with the 529 account. For example, parents and grandparents with taxable estates could establish a trust for the beneficiary and make annual gifts to the trust within the limits of the gift-tax annual exclusion. (When designing the trust, make sure contributions to it qualify for the annual exclusion.) Custodianship accounts under the Uniform Transfers to Minors Act can also receive annual gifts. The downside of the UTMA strategy is that the beneficiary has an unrestricted right to withdraw the funds at the statutory age, usually age 21. Finally, parents and grandparents who do not have taxable estates can establish investment vehicles in their own names to save for college expenses. Clients should liberally fund these supplemental gift vehicles. If all of the funds in an UTMA account or trust are not used for higher education expenses, they can be used—without adverse tax consequences—for other needs of the beneficiary, such as a down payment on a residence. Account owners and their advisors should always re-evaluate whether the 529 savings account is adequately funded before making a contribution. The 529 plan’s investments could grow faster than expected, college costs might increase slower than expected, or the beneficiary’s college aptitude or plans might change. 2. Estimate a Realistic Price of College To avoid overfunding the 529 savings account, be conservative when estimating the price of the beneficiary’s higher education. If the beneficiary is likely to attend a public university in a particular state or region, base estimates off of the cost of such schools. Don’t assume the beneficiary will attend a private university or MorningstarAdvisor.com 45 http://MorningstarAdvisor.com

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2008

Morningstar Advisor - Summer 2008 Contents Letter from the Editor Contributors Inbox College Planning: Solutions and Concerns ETFs: The Next Chapter Engineering Financial Advice Investment Briefs Flexible vs. Style-Pure Managers: The Evidence Forging a New Commodity Index Work Your Way Through College Planning Sizing Up the Options Best and Worst 529 College-Savings Plans A 529 Travel Guide 10 Tax-Smart Tips for College-Savings Planning Global Dialogue How Sequoia Cranks Out Good Returns Year After Year The Many Layers of David Winters Living on the Edge Stocks to Buy Once a Decade With Munis Feeling the Pain, Some Opportunities Arise Health Care Provides Shelter from Economic Storm Help Your Clients Get More Out of Their Bond Portfolios Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar New on MorningstarAdvisor.com Closer to Fine

Morningstar Advisor - Summer 2008

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