Many Americans make contributions to Section 529 plans to help their children or (more often) their grandchildren pay for their college education. The average balance in these plans today is a record $17,174, according to The College Savings Plans Network, and the total dollars is close to $200 billion.
Chances are you already know about these “IRAs for college,” where the earnings can grow tax-free, and the money can be withdrawn tax-free so long as it is used for federally-approved college costs. Each person can contribute up to $14,000 a year without triggering gift taxes, and through a special provision, you can make five years worth of contributions, moving money out of your estate into the hands of children.
Surprisingly, not everybody thinks this is the best way to save for college. For one thing, money in a 529 plan can count up to 5.54% of a child’s college savings in the financial aid worksheets used by most colleges and universities, which directly diminishes the potential for financial aid. More importantly, state 529 plans tend to offer limited investment choices, and the benefits of tax-free compounding are somewhat blunted by the fact that the assets should probably be invested conservatively since they’ll typically be needed before long by the student who is entering school. If you’re heavily invested in stocks and a 2008 hurricane blows through the investment markets, you risk leaving the college-age child with a tuition shortfall.
Is there an alternative? Section 2503(e) of the Internal Revenue Code provides that gifts that are made to an education provider, on behalf of kids, grandkids or any beneficiary, don’t count as taxable gifts. So instead of putting the money into a 529 plan, you could pay the child or grandchild’s tuition directly. No gift taxes required, no limited investment options, no money counted against the child’s need for financial assistance by the university’s endowment fund.
As your children or grandchildren will (hopefully) learn in their philosophy or business classes, there are times when simpler is better.