529, CSA and LSA: Gail Contrasts and Compares

Dear Readers,
Last week I outlined the new savings accounts proposed by the Bush Administration, including something called a "Lifetime Savings Account," or LSA. It would allow anyone to set aside up to $5,000/year. Earnings on your contributions would accumulate tax-free and could be withdrawn at any time and any age -- and used for any purpose.

That has some folks wondering if they should use an LSA instead of a 529 plan or Coverdell Education Savings Account to fund a child's college education. These accounts have a number of similarities.

None of them offer you a federal tax deduction for your contributions, which are made with after-tax dollars. And all three offer the potential for tax-free accumulation.

However, with a Coverdell ESA and 529 plan, this potential comes with strings attached. In the case of the Coverdell, withdrawals are only tax-free if the money is used for "qualified" education expenses incurred either in elementary, high school or college; 529 withdrawals are only tax-free if used for college or grad school expenses. Take money out of a Coverdell account or 529 for any purpose other than education and you will be hit with a 10-percent penalty on the earnings.*

So would you be better off using an LSA to save for a child's college education, knowing that, if you need the money for some other purpose, you could withdraw it without penalty or taxes?

A study done on behalf of the Senate Finance Committee concluded that since LSAs are more "flexible" than either a Coverdell or 529 account, they "could compete with the tax-favored savings programs for education -- particularly among person with limited disposable income."

Joe Hurley, a CPA with a website devoted to 529 plans, agrees that if -- and this is a big "if"-- Congress approved Lifetime Savings Accounts, they would attract some money that would otherwise go to 529s "because LSAs don't have the restrictions."

For some, however, that's exactly the point. How many people might be tempted to raid their kid's college fund if they suddenly needed the cash for, say, a home repair? Or just because they could no longer live without a high-definition TV?

Diana Cantor, who chairs the College Savings Plan Network, points out that 529 plans have restrictions "for good reason." She sees the penalty for using withdrawals on anything other than college expenses as a positive feature of these accounts. This might be especially true if anyone other than mom or dad is making the contributions.

As proposed by the Administration, anyone could contribute to an LSA on behalf of someone else. However, grandparents, for instance, might be less likely to part with the money for a grandchild's education if they knew it could be used for other purposes without any adverse consequences.

Another consideration is the annual contribution limit. With an LSA, that's $5,000. The maximum you can contribute to a Coverdell ESA on behalf of a child is $2,000. In contrast, there is no federal limit on annual contributions to a 529. In theory, you could contribute up to the account limit set by each state sponsor of a 529, which is well in excess of $100,000, subject to the annual Federal gift tax.

Even if you didn't want to part with that much money, unlike an LSA or Coverdell account, a 529 plan allows you to at least take full advantage of your annual gifting limit, which is currently $11,000 per year, per donor -- the maximum you can give without incurring gift tax. This means a couple -- grandma and grandpa, for instance -- could contribute $22,000 in a single year to a grandchild's 529 account. On top of that, other family members -- or anyone else for that matter -- can chip in. So a 529 allows you to set aside a lot more money, and faster, than either a Coverdell Education Savings Account or the proposed Lifetime Savings Account.

In fact, thanks to a special provision in the tax code, an individual can contribute as much as $55,000 to a 529 plan in a single year -- five times the annual gifting limit of $11,000 -- without incurring gift tax. (The donor has to survive for 5 years and can't make any additional gifts to that child during that period.)

529s also offer estate planning benefits. Money deposited into a 529 plan avoids estate tax. And yet, depending upon how you set up the account, you can still remain in control of the account until the day you die. You can even change the beneficiary. I have said this before, but it's worth repeating: there is not another account in America that offers this combination of estate tax reduction and control. (One caveat: 529s are subject to potential sunset on Dec. 31, 2010.)

Hurley points out another potential 529 advantage: some states offer a tax break to residents who contribute to their in-state plans.

But LSAs aren't the only proposal making state 529 sponsors nervous. The Treasury Department is proposing several changes aimed at discouraging "creative" investors from taking advantage of the tax-benefits of 529s by over-funding these accounts and essentially using them as tax shelters .

Trouble is, it's hard to make a case for widespread abuse of these accounts in light of the fact that, according to the College Savings Plan Network, the average 529 balance was just $7,820 at the end of last year.

Perhaps the biggest concern in the 529 world is that all this talk about LSAs and potential changes to 529 plans is making people put their college savings intentions on "hold" until the outcome is clear. This is probably a mistake.

Remember, LSAs were also proposed last year by the Bush Administration and went nowhere due to lack of support in Congress. And, if they're eventually passed, there may well be a way to convert a 529 into an LSA.

So don't let politics stop you from saving for a child's education. As Cantor puts is, "529s provide some of the greatest advantages for families to save for college. Don't wait to put money aside because you think something might change. Your children are growing up and they're not waiting."

Stay tuned for further details.


*Earnings on a 529 plan can also be withdrawn penalty-free if the child wins a scholarship and the money isn't needed for college.


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