The ABCs of 529 Plans

If you're already saving for college, you've probably heard about 529 plans. If not, you'll want to listen.

Introduced in 1996, 529 plans are revolutionizing the way parents, grandparents, and others save for college, similar to the way 401(k) plans revolutionized retirement savings. Americans are pouring billions of dollars into 529 plans, and contributions are expected to increase dramatically in the coming decade.

So where did these plans come from, and what makes them so attractive? Section 529 plans were created by Congress in 1996 in a piece of legislation that had little to do with saving for college--the Small Business Job Protection Act. The law on 529 plans was later refined in 1997 by the Taxpayer Relief Act, and again in 2001 by the Economic Growth and Tax Relief Reconciliation Act. In this short period, 529 plans have emerged as one of the top ways to save for college.

Section 529 plans are officially known as qualified tuition programs under federal law. The reason "529 plan" is commonly used is because 529 is the section of the Internal Revenue Code that governs their operation.

What exactly is a 529 plan?
A 529 plan is a college savings vehicle that has federal tax advantages. There are two types of 529 plans: state savings plans and prepaid tuition plans. Though state savings plans and prepaid tuition plans share the same federal tax advantages, there are important differences between them.

State savings plans
State savings plans let you save money for college in an individual investment account. These plans are run by the states, which usually designate an experienced financial institution to manage their plan. To open an account, you fill out an application, choose a beneficiary, and start contributing money. But once the money is in the account, you can't pick your own investments as you would with a Coverdell education savings account (formerly known as an education IRA), custodial account, or trust. Instead, the plan's professional money manager is responsible for investing the money in your account. All you do is decide when, and how much, to contribute.

With early state savings plans, plan managers commonly invested your money based only on the age of a beneficiary (known as an age-based portfolio). Under this model, when a child is young, most of the portfolio's assets are allocated to aggressive investments (e.g., stock mutual funds). Then, as a child grows, the portfolio's assets are gradually and automatically shifted to less volatile investments (e.g., bond funds and money market funds) to preserve principal. The idea is to take advantage of the stock market's potential for high returns when a child is still many years away from college, while recognizing the need to lessen the risk of these investments in later years.

Though the age-based portfolio is certainly logical (indeed, many parents were already trying to invest this way on their own), having only one investment option makes state savings plans in general seem a bit inflexible. After all, with some other college savings options (e.g., Coverdell ESAs, custodial accounts, mutual funds, and trusts) you can invest in practically anything (thereby taking into account your risk tolerance), and you have complete freedom to sell an investment that's performing poorly. Now, state savings plans are older and wiser. Today, more plans offer an array of portfolio choices.

So, in addition to choosing an age-based portfolio, you may also be able to direct your 529 plan contributions to one or more "static portfolios," where the asset allocation in each portfolio remains the same over time. These static portfolios usually range from aggressive to conservative, so you can match your risk tolerance. But keep in mind that state savings plans don't guarantee your return. If the portfolio doesn't perform as well as you expected, you may lose money. When it's time for college, the beneficiary of your account can use the funds at any college in this country and abroad (as long as the school is accredited by the U.S. Department of Education).

What's so special about 529 plans?

• Federal and state tax-deferred growth: The money you contribute to a 529 plan grows tax deferred each year. This means that instead of paying income tax on your earnings every year, as you would with a mutual fund or with investments held inside a custodial account, you don't owe any tax until you make a withdrawal from the plan.
  
• Federal tax-free earnings if the money is used for college: If you withdraw money to pay for college (known under federal law as a qualified withdrawal), the earnings part of the withdrawal is completely tax free, similar to the tax treatment of education IRA earnings. This is perhaps the single greatest advantage of 529 plans.
  
• Favorable federal gift tax treatment: Contributions to 529 plans are considered completed, present-interest gifts for gift tax purposes. This means that contributions qualify for the $12,000 annual gift tax exclusion (2008 figure). And with a special election, you can contribute a lump sum of $60,000 to a 529 plan (2008 figure), treat the gift as if it were made over a five-year period, and completely avoid gift tax.
  
• Favorable federal estate tax treatment: Your plan contributions aren't considered part of your estate for federal tax purposes. You still retain control of the account as the account owner without paying a federal estate tax on the value of the account. But if you spread today's gift over five years and you die within the five years, a portion of the gift will be included in your estate.
  
• State tax advantages: States can also add their own tax advantages to 529 plans. For example, some states exempt qualified withdrawals from income tax or offer an annual tax deduction for your contributions. A few states even provide matching scholarships or matching contributions.
  
• Availability: Section 529 plans are open to anyone, regardless of income level. And you don't need to be a parent to set up an account. By contrast, your income must be below a certain level if you want to contribute to a Coverdell ESA or qualify for tax-exempt interest on U.S. education savings bonds (Series EE bonds, which may also be called Patriot bonds, and Series I bonds).
  
• High contribution limits: The total amount you can contribute to a 529 plan is generally high. Most plans have limits of $250,000 and up. Coupled with the tax-deferred growth of your principal and the income tax-free treatment of qualified withdrawals, it's easy to see how valuable your money can be in a 529 plan.
  
• Professional money management: For college investors who are too busy, too inexperienced, or too reluctant to choose their own investments, 529 plans offer professional money management.
  State savings plan variety: In many cases, you're not limited to the state savings plan in your own state. You can shop around for the plan with the best money manager, performance record, investment options, fees, and customer service. (You can't generally shop around with prepaid tuition plans, though.)
  
• Rollovers: You can take an existing 529 plan account (state savings plan or prepaid tuition plan) and roll it over to a new 529 plan once every 12 months without paying a penalty. This lets you leave a plan that's performing poorly and join a plan with a better track record or more investment options (assuming the new plan allows nonresidents to join).
  
• Simplicity: It's relatively easy to open a 529 account, and most plans offer automatic payroll deduction or electronic funds transfer from your bank account to make saving for college even easier.
  
• Innovation: Section 529 plans are a creature of federal law, but the states are the ones that interpret and execute them. As Congress periodically revises the law on 529 plans, states will continue to refine and enhance their plans (and their tax laws) in order to make them as attractive as possible to college investors from all over the country.

What are the drawbacks of 529 plans?
No college savings option is perfect, and 529 plans aren't, either. One major drawback of 529 plans is that you have little control over your investments. With a prepaid tuition plan, the plan's money manager is responsible for investing your contributions. Although your investment return is usually guaranteed, you generally don't enjoy any surplus returns that the plan may earn.

With a state savings plan, you may be able to choose among a variety of investment portfolios when you open your account, but you can't direct the portfolio's underlying investments. And unlike a prepaid tuition plan, your investment return is not guaranteed. If you're not happy with the portfolio's investment performance, you might be able to direct future contributions to a new portfolio (assuming your plan allows it), but it may be more difficult to redirect your existing contributions. Some plans may allow you to make changes to your existing investment portfolio once per calendar year or upon a change in the beneficiary. But in either case, it depends on the rules of the plan.

However, there is one option that's allowed by federal law and that isn't subject to plan rules. You can do a "same beneficiary" rollover (a rollover without a change of beneficiary) to another 529 plan (a state savings plan or a prepaid tuition plan) once every 12 months, without penalty. This gives you the opportunity to shop around for the investment options you prefer.

The second major drawback of 529 plans will become apparent if you need to use the money in the account for something other than college. With a state savings plan, you'll pay a penalty on the earnings portion of any withdrawal that is not used for college expenses (a federal 10 percent penalty; a state penalty may also apply), and you'll pay income taxes on the earnings, too. With a prepaid tuition plan, you must either cancel your contract to get a refund or take whatever predetermined amount the plan will give you for a nonqualified withdrawal (some plans may make you forfeit your earnings entirely, others may give you a nominal amount of interest).

Yet despite these drawbacks, 529 plans have many unique advantages that certainly merit a closer look if you're in the college savings game.

What to Plan for as Parents Age

Life transitions often affect our plans for how we use our financial assets. One common transition is assuming responsibility for caring for parents as they age.

To gain some outside perspective on this responsibility, we turn to gerontologist and eldercare advisor Esther Koch. Esther, who was recognized for her expertise when she was selected as a delegate to the 2005 White House Conference on Aging, runs a business which focuses on educating adult children on how to plan for caring for aging parents. Her insights were helpful for us, and below is a summary of some of her suggestions (along with a few of our own).

Start Discussions Early
As you transition into this stage of life, it is important to recognize that aging is an emotional and family-related issue. Often, family dynamics create roadblocks to what could be successful aging—which Esther eloquently described as “putting life into your years, rather than years into your life.” It takes courage on the part of both the parent and child to get past denial that aging is taking place, and that care is likely to become an issue at some point in the future.

Unfortunately, aging is a process of decline that usually happens through abrupt triggering events, rather than in a smooth line. Therefore, it is never too early to start talking about care planning—and best to have these discussions when your parent is well. Discussions about future needs will be easier before these events take place, when your parent is not yet dependent on care.

Review and Update Legal Documents
During your discussions, a primary topic to address is your parent’s legal documents. The following is a list of basic documents, and some suggestions for what to emphasize in your review:

Advance Health Care Directive (AHCD): This document outlines how your parent would like specific potential health issues to be addressed, and then names a person to act as the agent of the directive, as well as backup agents.

• Special consideration should be given to the individual named as an agent—sometimes the best person for this job isn’t the person handling financial assets, but someone specifically suited to carrying out and respecting your parent’s health care wishes.
  
• Families without this directive, such as the publicly known case of Terri Schiavo, can suffer through very difficult medical decisions. Therefore, it is truly a gift your parent can give your family by completing this document.
  

Power of Attorney (POA): This type of document names a person in addition to your parent who has the right to authorize financial transactions for him or her on named assets or accounts. A few important things to know about POAs, and to know about your parent’s POA:

• There are different types of POAs: Some of which “spring” into action upon specific health events, and others that are “durable” to cover any situation.
  
• Some allow for the sale of real estate, or the transfer of ownership of real estate to a trust, and some do not.
  
• Many financial institutions require their own specific Power of Attorney form to be completed in addition to one a lawyer may have created.
  

Trusts: As you likely know, trusts are legal entities that can own assets and designate trustees and successor trustees to control the management and distribution of those assets according to the rules of the trust. Here are some basic things to check with your parent about his/her trust(s):

• Have the assets, such as bank accounts, investment accounts, retirement beneficiaries, or property, been renamed or “registered” in the name of the trust (or are they still in the name of your parent)?
  
• Are the designated trustee(s), and successor trustee(s), up to date with current wishes, and are they the most appropriate people to handle financial decisions for your parent?
  
• If your parent is the current sullen trustee of the trust, would he/she be comfortable naming one of the intended successor trustees as a co-trustee (which can be a more easily accepted form of recognized authority by financial institutions than a power-of-attorney)?
  
• Are the trust’s rules about the eventual distribution of assets up-to-date with current wishes?
  
• Does the trust plan for a tax-efficient transfer of assets for a large estate, possibly with the use of a bypass trust if your parent is married, and are those instructions up to date with current estate laws?
  

Wills: Although most assets may be covered by a trust, a will describes your parent’s intentions for non-financial assets, personal effects, etc. Additionally:

• A will can have a “pour-over” clause, which would help gather any assets not yet registered in the name of the trust and “pour” them into the trust’s control.
  
• A will names a specific person as the “executor” of your parent’s estate, which will be the person responsible for handling all the steps of distributing the estate according to the instructions in the will. Again, this person should be carefully selected.
  

Prepare for the Costs of Long-Term Care
Although this may be a difficult discussion, it is important to talk about how the costs for future care (that your parent may need) will be covered. Esther feels that many people are woefully under-prepared for the high costs of long-term care, especially in today’s world where the model of caring for parents in our homes is not as easy as it once was. Aging parents are living longer, and children of aging parents are working longer, so the financial and physical burden of keeping a working spouse at home to provide care is too great for many families to bear.

The first trigger for needing some assistance is often the loss of some skill or awareness, such as processing mail, preparing meals, using the telephone, handling finances, managing medications, etc., which are considered the “incidental activities of daily living.” Later, the triggering events for needing long-term care would be the loss of more basic “activities of daily living,” such as bathing, dressing, eating, walking, etc. Hiring someone to provide assistance with these functions would not be covered by medical insurance, but the loss of “activities of daily living” can trigger cost coverage by long-term care insurance.

The cost of long-term care can be high, and it increases as more assistance is required. Here are some examples:

• Home aide, providing assistance and care in the home can cost $25 per hour. On a 24 hour-a-day/seven-day-a-week basis, that is over $16,000 per month. This does not include the cost of food, housing, maintenance, etc.
  
• Assisted living, which provides housing, maintenance, meals, and a social environment, can cost $2,500 to $5,500 per month in California. The higher cost providers often have bigger rooms, nicer grounds, or provide more care services. Adding supplemental care or attention may involve extra fees.
  
• Skilled nursing, which provides housing, maintenance, meals, and social activities, along with a level of medical care requiring a higher level of licensing. This level of care can cost $165 to $350 per day in California, or about $5,000 to $11,500 per month. At this level of service, there can still be a need to add supplemental care or attention (at additional costs).

To cover these costs, you may have multiple sources, including your own or your parent’s savings and financial assets, health insurance, long-term care insurance, and/or possibly a pension or other income. The bottom line is that it’s important to recognize that the costs of long-term care can be significant, and they will likely only go up from here. It’s a good idea to start discussions now about which resources will be the best to target for these future needs.

Determine the Best Living Situation
In the evaluation of the best living situation for your parent, it is important to consider his or her social situation, because studies have found that social isolation can lead to depression and overall diminished health. Esther has also noted that some studies have even shown a link between isolation and Alzheimer’s. For this reason, it is sensible to determine ahead of time what living situation might be the best one for your parent.

In addition to physical health, Esther says that one of the keys to successful aging is emotional well-being. Social support is the most important component in improving one’s emotional health, and having a positive attitude and a sense of humor also help. All of these can be fostered by being around positive people. Although many people think they would like to live at home as they get older, if that means they will be alone much of the time it may not be the best option. Planned retirement communities, or assisted living facilities, may feel less independent, but they can offer more social interaction.

Summary
In summary, it’s never too early to begin discussions with your aging parent about their future care needs, an ideal living situation, how costs will be covered, and a review of legal documents. To counter the emotional burden you may feel in the care-planning process, Esther suggests that you think of yourself not as just a caregiver, but also a “facilitator of experiences” for your parent. Plan carefully for how you allocate the time you have together, and don’t forget to take opportunities to create special memories.

Market Volatility

No doubt about it, there’s a “Whole lotta shakin’ going on” in the stock market these days. We’ve seen the headlines about big daily advances and declines in the markets and Standard & Poor’s has now confirmed that U.S. stock volatility has climbed to its highest level in 70 years. As reported in a March 20 article from Bloomberg, Standard & Poor’s said the benchmark S&P 500 Stock Index has advanced or declined 1% or more on 28 days in 2008 through mid-March. That came out to 52% of the trading days, which is the highest percentage since 1938. Back in 1938, the comparable number was 57%. Interestingly, despite the volatility in 1938, the S&P 500 actually rose 25% that year.

For a little historical perspective, going back to 2002, the S&P 500 had 1% moves 50% of the time. In 2006, that figure dropped to 12%. It rose slightly to 13% in the first half of 2007, then soared to 39% in the second half of the year.

While the overall market is experiencing volatility, the daily swings in certain individual stocks is also quite astonishing. For example, on March 17, Merrill Lynch had a high price of $42.42, a low of $37.25, and it closed the day at 41.18, according to data from Yahoo! Finance. That’s a drop of 12% from its high to low and a rise of 11% from its low to its close – all in one day! However, that pales in comparison to the trip that Lehman Brother’s stock took that same day. It had a high price of $34.91, a low of $20.25, and it closed at $31.75. That’s a drop of 42% from its high to low and a rise of 57% from its low to its close – again all in one day!

It’s very unlikely that the value of those companies changed by that much in one day. Instead, what we saw on March 17 was an extreme emotional reaction to unfolding events. Fear is a very potent emotion and it was on grand display that day. The significant movements may also suggest that investors (or speculators) still lack strong conviction about the future direction of the market.

As it relates to you, the market action on March 17 will likely just be an interesting footnote, if that. These large daily swings make great headlines and are fodder for the talking heads, but to long-term investors, they are just a blip.

Volatility can be scary and it tends to shake out the “Nervous Nellies”. For investors who have an historical perspective, and who have an understanding of how emotions can play out in the financial markets, volatility may be an ally. After all, if there was no risk to investing, there’d also be no significant return.