A Tax Shelter That Can Pay for College

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529 plans are one of Washington's best incentives to save, especially for high-income people.

 

If you're worried about the cost of your children's higher education, Uncle Sam has a nifty solution: 529 plans. The accounts are sound vehicles for paying tuition bills. And for high-income households, 529s have an additional appeal: under the law, you can put up to $10,000 a year into a tax-sheltered account that will pay for a child's education.

 

Parents with deep pockets can accelerate the savings process, putting $50,000 into an account the first year. After that, the saver must wait five years to make more contributions. “For affluent families, this is one of the best tax shelters around,” says Wade Smith, a financial advisor in Seattle.

 

Making the maximum first-year contribution offers considerable advantages. “Once the money is in the account, it is no longer subject to estate taxes, and there are no income taxes on the earnings,” says Kerry O'Boyle, an analyst for Morningstar. To increase the tax savings, your family can open more than one ac-count.

 

Say you have three children. You can put $50,000 in each child's account. Grandparents can also put $50,000 in each of the accounts. The beneficiaries need not be blood relations. You can put money aside for the child of a friend.

 

If the money is spent on education, you need never pay taxes on withdrawals. What happens if the youngster goes to a tuition-free school such as West Point? You can simply withdraw the money and pay income taxes. But better yet, you can change the name of the beneficiary on the account.

 

Consider grandparents who put $50,000 into a newborn's account, hoping that the child will make it to a top-tier institution. For 18 years, the money grows steadily in the tax shelter. The youngster proves to be a high achiever and wins a hockey scholarship to Cornell. But all the tax-free savings are not wasted. The money can remain in the account to cover graduate school expenses. Or the grandparents can assign the account to another child.

 

As tuition bills arrive, you may decide to raise cash by withdrawing the funds. But it may be smarter to pay tuition from your taxable account. You can leave the funds in the tax shelter as long as possible—perhaps cashing out the account when the child enters medical school—when the really stiff tuition bills begin to arrive.

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