Since their creation by Congress more than a decade ago, 529 plans have become an attractive way to save and invest for the college education of a child or grandchild. These plans have become popular, with assets reaching $117 billion at of the end of 2009. 

These 529 plans, so called because they were authorized by Section 529 of the Internal Revenue Code, allow any investment earnings the opportunity to grow free from federal and in most cases, state income taxes for the life of the account.

The Internal Revenue Service does not tax 529 distributions, nor do many state governments, as long as the distributions are used for qualified higher education expenses, such as tuition, room and board, mandatory fees, books and even certain expenses related to computers.1, 2

As of 2009, the amount of money donors may contribute has been raised to $13,000 per person—or $26,000 per couple filing a joint return—each beneficiary each year, without triggering federal gift taxes. All 50 states and the District of Columbia sponsor 529 plans; some states, in fact, offer more than one and typically offer a range of investment options.

These options may include (a) portfolios that invest in individual or an assortment of underlying mutual funds, with each one offering investment objectives ranging from aggressive to conservative; and (b) age-based portfolios that automatically shift to a more conservative balance of investments as the beneficiary gets closer to college age.  

Those assets may be used to pay for education expenses at any accredited college or university in the United States, as well as many foreign institutions, no matter which state’s plan you choose to participate in.

However, residents of certain states have an incentive to invest with their home-state plan, since they may be able to deduct annual contributions from that state’s income tax.

For example, New York State residents may deduct up to $5,000 per tax filer—$10,000 per couple—each year for a contribution to their state’s plan. In certain other states (e.g., Colorado, New Mexico, South Carolina and West Virginia), contributions by residents to the home state plan are fully deductible.*

In addition, five states (Maine, Kansas, Pennsylvania, Arizona and Missouri) have passed legislation that provides residents with a state tax deduction if a contribution is made to any state 529 plan.

The 529 plans have an additional benefit for parents who have already begun saving for a child’s education through a custodial account under the Uniform Gift/Transfer to Minors Act. Historically, these custodial accounts were attractive because when the child took control of the money to pay for education expenses (at either age 18 or 21, depending on state law), the distributions were taxed at the child’s tax rate.

Beginning in 2009, however, those distributions were taxed at the parents’ higher tax rate for full-time students under the age of 24 for any investment income greater than $1,900.

You may be able to improve the tax efficiency of the Uniform Gift to Minors Act and Uniform Transfer to Minors Act (UGMA/UTMA) accounts by transferring the assets to a “custodial” 529 plan.

The transferred funds still belong to the minor child, who is allowed to take control of the money when he or she reaches the age mandated by state law. A “custodial” 529 college savings plan for a dependent student has a lower impact on financial aid eligibility.

Taxes on any capital gains could increase after 2010, when current tax rates sunset, so you should speak with your tax advisor to determine if transferring UGMA/UTMA assets now is likely to have the smallest tax consequence.

Besides improving your child’s chances of receiving federal financial aid, putting a 529 wrapper around those assets may help ensure that he or she will use those savings for college.

Because only cash may be contributed to a 529 plan, UGMA/UTMA assets must be liquidated to make the transfer, potentially triggering capital gains. Depending on the child’s age, the benefits of potential tax-free growth over a short time period may not outweigh the tax consequences of liquidating the UGMA/UTMA account.

You should also consider any potential fees, expenses, sales charges and/or penalties for selling investments before making the transfer. Talk to your financial advisor and your tax advisors to determine if this strategy is suitable for you. 

In addition to potential state tax-deductible contributions and federal tax-free withdrawals, noncustodial 529 plans provide a valuable tool for estate planning. You have the option of “front-loading” five years worth of contributions in a single year without incurring gift taxes.

An individual may contribute up to $65,000 per beneficiary in one year, or $130,000 from a couple filing a joint return. If you donate the full amount, you use up your gift tax exemption for the next five years.3 Any other gift given to that same individual during those years is taxed as a gift.

For all the advantages of 529s, there are a few key caveats to consider before committing the funds. The investment options are limited, and account holders are permitted to change their options only once per a calendar year, restricting your ability to respond to market changes. Of course, there is always the risk that investments in a 529 plan can go down in value. 

Talk with a financial advisor to find the best college-savings options for your situation.

* Source: www.savingforcollege.com.

Chuck Toth is the director of personal retirement product management at Merrill Lynch Wealth Management.

Before you invest in a Section 529 plan, request the plan’s “program description” from your financial advisor and read it carefully. The “program description” contains more complete information, including investment objectives, charges, expenses and risks of investing in the plan, which you should carefully consider before investing. You should also consider whether your home state or your designated beneficiary’s home state offers any state tax or other benefits that are available only for investments in that state’s 529 plan.

Please remember there’s always the potential of losing money when you invest in securities.

Neither Merrill Lynch nor its financial advisors provide tax, accounting or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Please consult your own independent advisor about any tax, accounting or legal questions you may have.

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[1]To be eligible for the favorable tax treatment afforded to any earnings portion of withdrawals from Section 529 accounts, withdrawals must be for “qualified higher education expenses,” as defined in the Internal Revenue Code.

[2] Tax-free withdrawals for computers apply only for such expenses that are incurred in 2009 and 2010

[3] Contributions between $13,000–$65,000 ($26,000–$130,000 for married couples filing jointly) made in one year can be prorated over a five-year period without incurring gift taxes or reducing your federal unified estate and gift tax credit. If you contribute less than the $65,000 ($130,000 for married couples filing jointly) maximum, additional contributions can be made without incurring federal gift taxes, up to a prorated level of $13,000 ($26,000 for married couples filing jointly) per year. Gift taxation may result if a contribution exceeds the available annual gift tax exclusion amount remaining for a given beneficiary in the year of contribution. For contributions between $13,000 and $65,000 ($26,000–$130,000 for married couples filing jointly) made in one year, if the account owner dies before the end of the five-year period, a prorated portion of the contribution may be included in his or her taxable estate. Please consult your tax and/or legal advisor for such guidance.