If you have a child (or if you'd like to help someone else's child) who is going to attend college in the future, you should know that many states, including the State of California, has set up a qualified state tuition program (also called a "Section 529 Plan") that allows either the prepayment of, or the creation of an investment account for, higher education costs on a tax-favored basis. Funds that you, the donor, place in either the prepayment account or the investment account will be used to cover the future higher education costs of the child you designate as beneficiary. The earnings on the account are not taxed while the funds are in the Section 529 Plan. Distributions from a Section 529 Plan will be excluded from gross income to the extent they are used to pay for qualified higher education costs.
Tuition, fees, books, supplies, required equipment, and reasonable room and board expenses are all considered "qualified higher educational costs" under the Section 529 Plan.
Accredited colleges, junior colleges, and area vocational schools are qualified to participate in the Section 529 Plan. In addition, accredited post-secondary schools offering credit towards a bachelor's degree, an associate's degree, a graduate or professional degree, or another recognized post-secondary credential, are eligible to participate.
The contributions the donor makes to the Section 529 Plan are not subject to gift tax, except to the extent the contributions exceed $10,000 annually (indexed for inflation). And if contributions in a year exceed $10,000 (as indexed for inflation), the donor can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Thus wealthy grandparents (or parents) can give $100,000 ($50,000 each in year one) and prorate the gifts over five years. However, a death by a donor during this five year period will draw back a prorated amount of the gift into his or her gross estate for estate tax purposes.
A distribution from a qualified program is not a gift. A change in beneficiary or rollover to the account of a new beneficiary is considered to be a gift made by the original donee/beneficiary if the new beneficiary is a generation below the original donee/beneficiary.
No amount of the Section 529 Plan account is includible in the gross estate of the donor although the donor retains the right to change the beneficiary and the right to decide when distributions for educational costs are made.
There is no age limit on the beneficiary of the Section 529 Plan. Theoretically, the assets in the Section 529 Plan account could grow tax-free for decades until the beneficiary needs the funds to pay for college or vocational school in order to launch a second career.
Distributions from the Section 529 Plan which are not used for educational expenses will incur for the donor a 10% penalty in addition to federal and state income tax. Exceptions to this rule exist. E.g. if the beneficiary qualifies for a scholarship and thus does not need a portion of the account, the amount of distribution not exceeding the scholarship will not be taxed or suffer the penalty.
Contributions to a Section 529 Plan must be in cash. No real estate or securities can be accepted. An existing non-529 Plan, such as an Uniform Transfers to Minor Act account, would have to be liquidated before transferring the funds into the new Section 529 Plan account.
In accordance with federal law, which established the Section 529 Plan, a state must select a professional investment manager to help create investment savings vehicles. The donor and the beneficiary must have no influence on, or direction of, the investment portfolio. However, most investment managers will give the donor a variety of investment portfolios to choose from at the original funding of the Section 529 Plan account. A typical portfolio may be heavily weighted in growth assets during the early years of the account, and then gradually switch to less volatile income producing assets during the later stages.
A Section 529 Plan has many advantages over other college-saving techniques such as an Educational IRA, a Uniform Transfers to Minor Act account, Series EE bonds, etc. These advantages are: The tax advantages will apply regardless of the gross income of the donor; the account can be used for more than just tuition; the earnings and distributions are not taxed to either the donor or the beneficiary (although non educational distributions generally will be); the donor retains control over the naming of beneficiaries and timing of distributions without having the funds included in his or her estate, and more. One possible disadvantage to a Section 529 Plan is that the account will be considered available to the beneficiary and will likely reduce or eliminate scholarship awards.