529 Plans: The Basics
Consider Education Savings Plans
A 529 plan is a popular option for families saving for a child's college education, and for good reason. Although the plans differ from state to state, they are all exempt from federal income tax, and that can give a real bottom-line boost to your college fund.
What Is a 529 Plan?
A 529 plan is a state-operated investment plan that gives families a federal tax−free way to save money for college. They are officially known as qualified tuition programs (QTPs), but commonly referred to as "529 plans," "state 529 plans," or "Section 529 plans" after the section of the IRS code that provides the plans' special tax breaks.
These are the basic terms of 529 plans:
- Earnings and withdrawals are exempt from federal taxes, as long as they go toward paying college costs.
- Earnings are subject to a penalty if funds are withdrawn for purposes other than education.
- State taxes are waived in some states for residents; deductions on contributions are allowed in others.
- High maximum contribution limits are allowed — sometimes up to $375,000 per beneficiary.
- Contributions are considered completed gifts and are excluded from estates, which makes the plans attractive to grandparents, who can change the beneficiaries to other grandchildren as funds are needed.
Two Types of 529 Plans
These plans come in two varieties — college savings plans and prepaid tuition plans. Nearly every state has at least one of these two options and many states offer both.
1. College savings plans let you use funds for college expenses at any college. Qualified education expenses include tuition, fees, room and board, books, and supplies. This plan gives you much greater flexibility in college choice.
These plans are open to anyone, are easy to manage, can be used at most schools and don’t significantly affect financial aid. The account holder controls the money, large contributions are possible and there are gift tax exemptions.
On the downside, the plans offer limited choices and involve risk. As with other mutual funds or market-driven investments, there is always the possibility of fluctuating returns or low performance. These plans have less investment disclosure and there may be account manager fees.
2. Prepaid tuition plans, also known as Prepaid Education Arrangements (PEAs), let you lock in future tuition at in-state public colleges at present prices. The value of the investment is guaranteed by the state to meet or exceed annual public college tuition inflation in the state where you are attending college. Plan costs can vary, depending on how close the student is to college.
The advantage of these plans is that they are low risk and guaranteed.
However, they are limited to state residents, are geared toward in-state public institutions and have a narrow definition of college expenses. The investments are conservative, financial aid treats the account as a parental asset, and the plans have significant refund and cancellation costs.
Each plan has its own set of rules and restrictions, which are subject to change. Make sure to request the most recent plan details from plan administrators. Get the facts about each plan, and decide which type might be right for you.
More Information on 529 Plans
Collegesavings.org is the College Savings Plans Network’s information clearinghouse of current 529 plans. They are an affiliate of the National Association of State Treasurers.
Savingforcollege.com is devoted to 529 plans and includes articles, FAQs and the site’s ratings of each state plan. It was founded by Joseph Hurley, a certified public accountant and 529 specialist.
IRS Publication 970, Tax Benefits for Education provides information on the tax benefits and consequences of 529 plans.
This information is general in nature and should not be construed as tax or financial advice. Consult your tax adviser or financial planner for more complete information.
