Making College Affordable--Even if You Didn't Plan Ahead

NEW YORK (MainStreet) — With the fall semester beginning, many parents and grandparents are thinking about how to cover college costs, whether for a student who's started college or for one with just a few years to go.

Tax-free Section 529 plans are a widely recommended college-savings option for young children, but what about these older kids? What's the latest you can put money into a 529 and still do better than the alternatives?

Answer: Pretty late, but only if you choose carefully.

These plans, set up by the states, allow parents, grandparents — or anyone, in fact — to escape federal income and capital gains taxes on investment earnings used for college. In addition, some states match that tax-free treatment on gains, and also provide income-tax deductions on 529 contributions. (The federal government does not.)

Tax exemption on investment gains make 529s a top choice in saving for young children, as earnings have many years to compound. In a big account — the kind sufficient to fund four years at a private college or university — the tax savings can total many thousands of dollars.

But if the beneficiary is already in college, or soon to start, there's little time to compound. Is there any reason, then, to use a 529 at this stage?

Yes — three.

The first would be to get that state income tax deduction on contributions. A majority of states offer some type of deduction. Even if the savings went into a money market account yielding almost nothing, a donor in a high-tax state such as New York could realize substantial tax savings on contributions.

Second, putting money into a 529 gets it out of the donor's estate. Because the estate tax exclusion is now $5.5 million, this isn't a factor for most people. But keep in mind that the estate includes one's home or homes, plus any life insurance benefits.

Finally, a late contribution could make sense for people who are willing to take substantial risk and believe their 529 investment could grow substantially in a short period. That could happen if your 529 is a mutual funds containing stocks. Or it could pay to invest in a prepaid-type plan, which grows in value in tandem with increases in tuition. If you thought tuition would rise substantially, you could lock in at today's cost.

Using 529s as a short-term speculation is obviously risky, as a volatile market such as today's could fall. So it's best left to donors who have other assets to cover college costs if things go wrong, or to those who, in a market downturn, could switch the account to benefit a younger child, leaving more time for the account to recover.

In thinking about a late-in-the-game 529 contribution, look carefully at your plan's rules, to be sure your state hasn't imposed any kind of minimum holding period that would derail your withdrawal plans.

Also, beware "broker-sold" plans that carry stiff commissions and fees. You'd probably do better with a "direct-sold" plan bought directly from a fund company, as fees will be much, much lower.

--Written by Jeff Brown for MainStreet

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