College Savings Plans that are known as "Section 529 Plans" are offered by individual states as a way to save for college while enjoying some tax benefits. Its name comes from the IRS code defining the details of the plan.
Looking at Your Options
A 529 plan is a state-sponsored investment program that each state sets up with the help of an asset management company. In most cases, you don't need to be a resident of a state to participate in that state's plan. There are a few states that restrict access to their plan to their own residents.
Although there are advantages to opening an account in your home state, you might consider the investment plans that several states offer to decide which one works best for you and your goals.
Two Types of Plans
There are two types of 529 plans available: a prepaid plan and a savings plan.
The prepaid plan lets you prepay tuition for a qualified educational institution at today's tuition rates. Not all colleges participate in this plan, but more are added to the list all the time.
The savings plan option lets you save money in an account with earnings that grow tax-deferred, to be used to pay for education expense when college comes around.
How They Work
The idea with either option is that the investment earnings will grow to meet the higher costs of future education. With the assumption that college tuition increases at a rate of about six percent per year, both plans are geared toward having your funds meet that increase.
The pre-pay option allows you to pay today's tuition rates for tomorrow's tuition. The savings account option seeks to make more interest than the rate of increase of college costs.
First, let's look at the option of pre-buying semesters or years of college.
Tomorrow’s Cost at Today’s Prices
The prepaid tuition 529 plan is similar to other types of state-sponsored prepayment plans. If you bought into a prepaid state tuition plan, you would prepay tuition with today's dollars for colleges in state.
Your payments go into an account that can only be used for schools within that state. If your child goes to an out-of-state school, your money is refunded, but usually with very little interest.
The Prepaid Advantage
The difference with a 529 plan is that you have more flexibility than you would with other prepaid in-state tuition plans. In the 529 plans, you prepay tuition that you can use at any of the constantly increasing number of member colleges.
Anyone who wants to contribute on behalf of a child can lock in today’s tuition rates, and the program will pay future college tuition at any of the member colleges or universities, whether in or out-of-state.
Prepaid plans sell tuition units (semesters or years) that you can buy as a one-time lump sum purchase or make monthly payments. That money is then pooled with other prepaid sums from other account owners and invested by the program in order to grow to meet (or even exceed) future tuition needs.
With many 529 plans, you get an additional discount on the amount you pay. For example, you might buy $5,000 worth of tuition, but you get an immediate 1% discount. Then you'd pay $4,950.
One Caveat. Be aware that when it comes to applying for financial aid, money paid out from the prepaid tuition 529 account offsets the eligibility for financial aid dollar-for-dollar. In other words, if your prepaid tuition account pays $10,000 for tuition one year, then your child will be seen as needing $10,000 less for financial aid.
529 Savings Plans
If you choose to invest in a 529 savings plan instead of the prepayment option, here are a few attributes to keep in mind:
- Nearly every state has a 529 savings plan, so there are many choices of types of investments.
- There are no income limits to participate in a plan.
- Investment plans are not controlled by the participants, but are locked in by the definition of that state's plan. In these plans, cash is generally allocated between stocks and bonds, often depending upon the child's age.
- Out-of-state residents may often participate in the plans, but would not be able to take advantage of tax deductions on withdrawals for state taxes.
- All of the plans allow benefits to be used at private or out-of-state colleges as well as in- be used for expenses such as room and board in addition to tuition.
- For most of the plans, parents and grandparents may take advantage of a one time aggregate contribution. The aggregate amount permitted varies by state.
- There are no guarantee that the account will grow enough to cover college costs. However, since these plans are invested in a wide range of securities, you have the opportunity to earn more than the cost of college.
- The money in these plans are usually held in the parents' names, therefore the funds do not count as heavily against the financial aid formula.
- If the money is not used for college at all, it would be refunded with a penalty, usually about 10 percent, which is set by the state that sponsors the plan. Withdrawals are then taxed at the parents' rate for ordinary income. However the growth in the fund could possibly offset the penalty.
- Money not used for one child's college costs could be rolled over for another child
- Some states allow an immediate deduction against state income taxes for contributions, with some limitations. States may also have other benefits such as a tax deduction, matching contributions, or withdrawals free from state income tax.
- Some states also allow you to roll custodial accounts into your 529 account.
All of the earnings in your 529 account are free from federal income tax at the time of withdrawal as long as they are used for qualified education expenses. Earnings on your account are currently tax-deferred in most states. And some states let you deduct a portion of your contributions from your state income taxes as well.
Unlike other types of custodial accounts the child does not gain control of the money at a specific age (usually 18 or 21 depending upon the rules of the state). The account owner always has control of the money. This keeps the parents in control of the college fund and not the student.
There are no restrictions on who can open an account for whom. You can open an account for your child, a friend's child, another relative, or even yourself. Anyone can contribute to the account.
There are no income limitations for opening a 529 plan, as there are with the Coverdell IRA.
In most states, there is no age limit or time limit for when the money has to be used. Your child can put off college indefinitely, in which case you have the option of rolling the account over to another child. As long as that child is in the same family as the first beneficiary, you can move the funds to another account. "Family," is defined as "the original beneficiary's spouse, children, sisters, brothers, nephews, nieces, first cousins, and any spouses of those persons."
An Advantage of Savings Versus Prepaid
Your child can go to any accredited degree-granting educational institution, whether it is public, private, two-year, or four-year. There are even some international schools that qualify. For the prepaid option, the college would have to be one of the member schools. For the savings plan option, it could be any accredited school.
In most states, qualified education costs include tuition, books, room, board, transportation, and even computers or other necessary supplies. If you withdraw the funds, there is no penalty assessed, just the tax.
In the event that your child gets a scholarship, then the remainder of the 529 account can be rolled over to another sibling (or other relative). Or you could cash out the account with no penalty other than the tax paid (at your rate) on the earnings. The same rule applies in the event of the child's death or disability.
OK, what’s the downside?
As much as 529 accounts are a great avenue for saving for college, it can affect your eligibility for financial aid. The 529 account is treated as an asset of the parent in determining eligibility for federal financial aid.
Here are some other issues:
Lack of Investment Control
Remember that when you invest in a 529 plan, you are putting your money in an investment company, not the state. The investment company manages the plan.
The investment plan varies by state, but once you invest in a plan with a particular configuration, you can't change the configuration of investments. If you are not happy with the plan you chose once you are in it, roll over your assets once per year, into another state's plan. There is no penalty for this rollover.
The Future of 529 Plans
Be aware that the tax exemption on 529 account earnings is in effect at least until 2011. At that time, Congress could vote to revert to the original plan in which the earnings are taxed at the child's rate. It is possible that Congress will revisit the 529 issue and vote to make the tax-free status permanent prior to the 2011 deadline.