Watch Out for Lifetime Limits on College Savings Plans

Many 529 plans have a maximum contribution amount, but earnings could also put a plan over.

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Parents who are able to save enough to fully fund their children's college education need to be aware of maximum aggregate limits on 529 plans, tax-advantaged higher education investment accounts.

A maximum aggregate limit is the total amount a family can deposit into a 529 plan in order to pay for a child's education. Having a limit can be good for families, as it prohibits them from stuffing college savings accounts at the expense of retirement accounts, experts say. Amounts taken out above the cost of higher education can result in a federal tax penalty.

College savings accounts from different states can have different limits, a potential source of confusion for families.

"Each state is required to calculate their account maximum and use different criteria to do so," wrote Mike Fitzgerald, chairman of the College Savings Plans Network, in an email. "At the end of 2012, the account maximum amount ranged from $400,000 to $235,000."

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But families don't have to stick to a plan from their state. For instance, if a family already knows a student will attend a private college and law school and they'll be able to save enough to cover expenses, they may not want to pick a plan with a maximum of $235,000 – even if it's from their state.

Some parents aspire to send their children to two-year community colleges, while others aspire to pay for their education all the way through medical school. While each state has different calculation methods and limits, all set a limit that should be enough for an undergraduate education.

For instance, the Utah Educational Savings Plan's current total limit is $397,000. The limit is based on the potential qualified higher education expenses of an undergraduate and graduate degree, including room and board, at the highest priced private or public university in the U.S., says Lynne Ward, executive director of the Utah Educational Savings Plan. An account's market earnings may put its total over the limit, she says.

Say an account reaches the $397,000 mark and contributions are no longer allowed. The student is only 10. Eight years later, the account may grow to $500,000 because of earnings on investments.

If market gains put the account over, the money can stay in the account without any sort of penalty. The family just can't contribute afterward, as long as there isn't a drop in the market that pushes the account back below the limit, experts say.

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Virginia's limit for its 529 plans is $350,000, based on calculations of seven years of qualified education expenses such textbooks and room and board. The maximum allowed balance may rise while the family is saving for college.

It doesn't matter whether families make the maximum total contribution to a 529 plan account all at once or over a period of years. An annual maximum on 529 plan contributions is just a myth. "Some people get confused in states where there are tax deductions and/or credits and think that is an annual maximum," Fitzgerald wrote.

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Parents in a state that allows $5,000 in 529 plan contributions to be deducted on their state income tax can contribute more than $5,000 a year to the account. If a family wanted to contribute $1,000 per month, they would be able to contribute the full $12,000 that year – they just wouldn't be able to deduct $7,000 of that on their state income taxes.

That $7,000 would only be rejected by the plan if the maximum total limit was reached.

While most middle-class families won't have to worry about going over maximum plan limits if they start saving on a monthly basis, families who start off with a large initial deposit, such as a $25,000 gift from a grandparent, may be surprised when they reach the cap.

If that family were to deposit $525 per month for 18 years and earn 5 percent interest, compounded annually, they would exceed the $235,000 cap some states set. Parents shouldn't underestimate the power of compound interest, especially when it grows tax-free in a college investment account.