Clearing up confusion on 529s

ALTHOUGH I CAN'T respond to every question I receive, I do try to address a financial issue if enough readers ask about a similar topic.

Such is the case following my column on tax-advantage 529 plans, which allow people to set aside money to help pay for college.

One reader wrote: "I have had an investment account that, for years, had substantial growth in asset value, which will be taxed when I sell. If I transfer the balance of this account to a 529, does that mean withdrawals of that money are free from federal taxes?"

The "qualified tuition program," as 529 plans are called in the tax code, was created as an incentive to get people to save for college. Earnings in a 529 are not subject to federal tax or, generally, state tax if the beneficiary uses the funds for educational expenses at a college, university, vocational school or other post-secondary educational institution.

So, no, a 529 plan is not a good tax shelter if you don't intend to use the money for education expenses. You will be hit with a 10 percent penalty, and you'll have to pay federal taxes on earnings.

Some people are reluctant to use this savings vehicle because of misconceptions and misinformation.

"I consider myself better versed than average about investing," another reader wrote, "but have avoided 529s for my grandkids because I didn't really understand them."

She had received conflicting information on the plans, and had the following questions:

* "Is the money in a 529 in the child's name? If so, what prevents that kid from using it to buy a car at graduation and blow it on bumming around the country in lieu of an education?"

* "You clarified that state-based plans don't limit the kid to that state, but do the plans themselves limit cashing in for tuition only?"

* "Is the 529 used against the kid in calculating his/her worthiness for need-based aid?"

I asked Joseph Hurley, founder of savingforcollege.com, one of the most comprehensive online sites about 529 plans, to help address the reader's concerns.

As to who owns a 529 account? It "remains under the control and ownership of the account owner - typically a parent or grandparent - and the beneficiary has no rights to the funds regardless of age," Hurley said.

Withdrawals can be used to pay not just tuition but fees, books and supplies, as well as room and board.

Other readers asked whether a 529 adversely impacts the "Expected Family Contribution" calculation, which determines financial aid eligibility. Often this question boils down to: "Isn't it better to appear less fortunate by not having money in a 529 plan so the student can get more financial aid?"

The value of the account set up by a parent or legal guardian is reported as an asset on the Free Application for Federal Student Aid, or FAFSA. But it only increases the student's expected family contribution by a maximum of 5.64 percent of the account value. "Tax-free withdrawals do not get reported as income on the FAFSA, which is very helpful," Hurley said.

If a grandparent or other relative opens an account, withdrawals for qualified educational expenses are counted as student income and will be assessed at 50 percent. So if you're concerned about impacting financial aid and you're a relative or grandparent, just contribute to a parent's plan. Or, if the plan allows an ownership transfer, you can set one up, fund it, and later transfer it to the parents.

Money withdrawn from the account will affect need-based aid because any financial support provided to the student by anyone who is not a parent or legal guardian, whether it comes from a 529 plan or any other source, is added to the student's reported income on the FAFSA, according to Hurley.

Some reading that last point might balk at contributing to a 529 plan. I've had parents and relatives complain and wonder why they should make sacrifices to save and fund an account when other families, who may be financially reckless and not save, will end up getting financial assistance for their child.

A lot of financial aid comes in the form of federal loans. And only 0.06 percent of students in bachelor's degree programs qualify for enough scholarships and grants to pay for the full cost of attending college, according to Mark Kantrowitz, publisher of Edvisors.com, a college-planning website. About 12 percent of students get scholarships and grants, and when they do, it averages just under $4,000 per year, he said.

These answers should make a convincing case for investing in a 529 plan.