Catch-22 for 529 College Plans

College savings programs, or 529 plans, are the federal government's way of urging any and every family to save for college by providing valuable tax breaks.

Employing a 529 to save for college used to be a no-brainer. But with the passage of last year's major tax act, reducing taxes on capital gains, dividends and income taxes, the case for the savings plans is less compelling, say some financial advisers.

In some situations, says Deborah Fox, founder of Fox College Funding in San Diego, "We can show people they would keep more money saving outside the 529."

Starting last year, dividend rates for taxable accounts have been reduced from ordinary income tax rates to 15% for those in higher income brackets and 5% for those in lower income brackets.

Taxes on gains from the sale of stock has been cut from 20% to 15% for higher income taxpayers and from 10% to 5% for lower income taxpayers. And the top four income tax brackets have shrunk by at least 2 percentage points, such as from 30% to 28%. (See related story and charts.)

Parents can give appreciated stock and securities to college-bound students, have them collect dividends at the lower 5% rate, or sell at the 5% capital gains rates and draw interest on the proceeds at the lower income tax rates until they pay educational expenses. Thus, the overall family's tax bill is lower.

In the seven years since the plans were created, the federal and state governments have refined and improved the 529, which, like the 401(k), is named for its section in the tax code.

Families who set up 529s can, however, run into some unexpected complications, says Fox.

It's possible, she says, that once students begin withdrawing funds from their college savings accounts, they could actually owe federal taxes on a portion of their supposedly tax-free 529s earnings -- if they receive scholarships or tuition discounts and/or use the IRS tax credits available to the middle class. (Families are eligible for either the Hope or the lifetime learning credit of up to $2,000 toward qualified educational expenses if their modified adjusted gross incomes fall between $41,000 and $51,000 for single filers and heads of households, and between $83,000 and $103,000 if married and filing jointly.)