The Basics to Opening a College Saving Account

Excerpted from 529 College Plan Made Simple by Richard A. Feigenbaum and David J. Morton ©2005

Establishing a College Savings Account is as simple as completing an application with one of the Plan Managers. Completing the application and getting started is relatively simple. Much like any financial investment, there are many different choices available for investing the assets. You must give thought to the duration, risk tolerance, and available investment options within the College Savings Account before you settle on an investment strategy.

Rules, Rules, Rules
The law is clear as to what is required of each state and of the consumer to achieve the benefits of tax-free growth on investments. To qualify for special tax treatment, federal tax law requires that the account must meet the following basic requirements.

• The account must be created under a state’s 529 Plan.
• The account may only receive cash contributions—no stocks, securities, or other business interests.
• No one—whether the owner, contributor, or beneficiary of the account—can have investment control over the account. Only the state—or its delegated investment firm—may direct the investments.
• Only certain maximum levels of funding are allowed.
• The College Savings Account cannot be pledged as collateral or security.
• The program, as administered by the states, must provide a separate accounting for each beneficiary of a plan.
• The College Savings Account must be used for qualified higher education expenses.
• The College Savings Account funds must be used at an eligible educational institution to have all gains and appreciation be tax-free at the time of distribution.

The Account must be Created Under a State’s 529 Plan
By requiring each state to adopt its own plan (rather than a uniform national plan), each state can tailor and modify the plan as it sees fit. This will allow for changes and improvements as the years go on. While the industry is still in its infancy, differences among the states have started to occur and changes are being adopted on a frequent basis. Understanding the differences among these state plans, when coupled with the many investment options and the returns on the account assets, can help a well-informed consumer select the appropriate College Savings Account. It can also confuse the consumer who, without a professional advisor, may wander aimlessly among the options. This may result in an inability to even get started opening an account.

Differences Among the Plans
Some College Savings Accounts are only available to those who reside in the state. Some plans are available to non-residents, but only through a broker—who typically will charge a sales commission or an annual fee during the period of time the assets are invested in the plan.

Each state has its own rules about whether a resident investing in his or her state’s plan gets a special income tax deduction. In addition, each state has its own rules about whether the withdrawal of funds from an account will be income tax-free or taxable at the time of withdrawal.

Some plans have enrollment fees, an annual account maintenance fee, asset-based management fees, and an underlying fund expense. These fees are often in addition to that which is paid to the advisor assisting in the opening of the College Savings Account.

There are also differences stemming from the choice of investment options (or lack of options). Some plans have investment choices based on the consumer’s preference or tolerance for risk (e.g., growth, balanced, aggressive growth, bond fund) and exposure to the marketplace. To gain a competitive edge, the Plan Managers continue to increase the consumer’s options in an effort to give them some measure of control over the selection of investments.

The Account may only Receive Cash Contributions
Under the law creating College Savings Plans, it is absolutely clear that only cash can be used to open or contribute to a College Savings Plan. This seemingly innocent requirement does create an issue for those who have been saving for college for some time now. For many years, the traditional approach to saving for college has been to utilize an account titled in the child’s name under the Uniform Gift to Minors Act (UGMA) or its more modern relative, the Uniform Transfers to Minors Act (UTMA).

Governed by individual state’s laws, these UGMA/UTMA savings accounts are taxable investment accounts, with all taxable income taxed to the child. Under these kiddie tax laws, income and capital gains of a child under 14 are taxable to the parents, and after age 14, are taxable to the child. Certainly, those with existing accounts will seek a way to transfer the existing account into a College Savings Account.

Unfortunately, the UGMA/UTMA account is normally not invested in cash, and would require that all the investments in the account be sold and converted to cash before the money could be transferred to a College Savings Plan. This liquidation would result in taxable income if the account had appreciated (gone up) in value.

You cannot have Investment Control Over the Account
Only the state or its Plan Manager (the designated investment firm) may direct the actual investments of the account, while the owner, contributor, or beneficiary of the account cannot. For the consumer, this means that there is a loss of control over the investing of assets. For many, this may be the best possible thing. For others, it will create a frustration over seemingly lost opportunities.

To provide more flexibility to the consumer without violating this mandate, the Plan Managers have begun offering more than just age-based investment options. Many Plan Managers now allow for risk-adjusted options within these age-based approaches.

When a College Savings Account is opened, the person who opens the account is very often labeled the owner. The owner is the person who has the ability to name the beneficiary, change the beneficiary from time to time, and withdraw funds from the account. While being prohibited from having direct control over investments, the account owner can gain some measure of control by searching for a Plan Manager that provides the options that meet with the account owner’s liking.

Given that the many Plan Managers will each have their own selection of funds and alternative investment options, account owners may look for opportunities to chase the best return in the marketplace. (Chase means to try to time the market by jumping in and out of investments.) To prevent an account owner from gaining control (indirectly) of the investments by shifting from one Plan Manager to another, the law prohibits the transfer of an account more than once per year.

Only Certain Maximum Levels of Funding are Allowed
Remember, these plans are designed for the purpose of saving for college. Parents can save for children; grandparents for grandchildren; charities can save for scholarships; aunts, uncles—everyone can save for everyone, but not too much. Even as expensive as college is, there is a limit. The law only allows for the saving of money for qualified higher education expenses. Since the law allows each state to implement its own sets of rules, this is one area that will vary from state to state. As you compare state-by-state plans, you can see differences in the maximum funding level.

For instance, in 2003 in the state of Rhode Island, the maximum funding level was $301,550, while in New Hampshi

As Featured in the Book

529 College Savings Plan Made Simple

Richard A. Feigenbaum Attorney at Law, David J. Morton, Attorney at Law

Few things can keep a parent awake at night like the seemingly daunting task of saving for a child's education. Thankfully, the government has created the single greatest savings opportunity in many years---the 529 College Savings Plan.

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