On the surface '529 plans' appear to be
a great idea. As long as the money is used to pay for qualified
higher education expenses, the money can be withdrawn tax-free.
However at the bottom of 529 savings plan applications in small
print is the disclaimer; *The IRS may require you to substantiate
that your withdrawal is qualified. So the question is, what is
considered a qualified withdrawal?
The standard definition provided by much
of the financial media, financial web sites, and commissioned
based advisors selling 529 plans, goes something like this. "The
earnings on the investments in a 529 savings plan will not be
taxed by the federal government as long as they are used for qualified
higher-education expenses (which include tuition, books, and room
and board)." There is however one word left out of the above
definition that can make a big difference as to which expenses
are considered qualified, and which are not. According to Section
529(e)(3), of the Internal Revenue Code "qualifed education
expenses are the tuition, fees, books, supplies, and equipment
that are ("required") for enrollment or attendance at
an eligible educational institution." And so far, the IRS
and US tax courts include the word "required" in their
determination of what is considered a qualified expense as well.
In 2001, the IRS audited a couple claiming
the money they withdrew to pay for their daughter's college tuition,
books, a computer, and room and board furnishings were not "required
qualified higher educational expenses". In August of last
year, a U.S tax court ruled that the savings the parents used
to pay for their daughters tuition, was a "required"
qualified expense. The court however agreed with the IRS and upheld
the taxes and 10% penalty on the earnings used to purchase a computer,
books, and furnishings for their daughter's dorm room. According
to the court, the school did not "require" students
to have a computer. Plus the school provided a limited number
of computers for students to use in the library. In addition,
their daughter was not enrolled in any classes that "required"
her to have her own computer. The purchase of appliances, furniture,
and bedding to furnish their daughter's dorm room was not "required"
by the university and, therefore, was disallowed. The money spent
on books was disallowed because the parents didn't have all of
the receipts to prove the money withdrawn was used to purchase
the books. In addition, none of the books were (you guessed it)
"required" for their daughter's enrollment or for any
specific class.
During a recent college savings seminar,
I was asked which 529 savings plan I liked best. I mentioned how
my wife and I are saving for our 9 year-old son's college education
and that we have not invested have one cent of this savings in
any 529 plan. Contrary to the sales pitches of most the investment
industry, saving for something as important as a child's future
in a college savings plan loaded with numerous restrictions, constantly
changing rules and regulations, high fees, commissions, limited
investments and asset allocation choices in the hopes of saving
some money in taxes is loaded with risk. An alternative to 529
plans is saving for college in a mutual fund account comprised
of no load mutual funds. With a mutual fund account, there are
no conditions or restrictions in place that determine when, what,
or how the money has to be invested, managed, or spent. (See
accompanying chart)
