What are 529 Savings Plans?

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With school back in session many families are trying to figure out how to pay for college. A great option would be opening a 529 plan. This is a savings plan that offers special tax advantages and are specifically designed to help people  save up money for college. 529 plans are technically referred to as a “qualified tuition plans,” and they are sponsored by states, state agencies, and educational institutions.

Two Types of Plans

All fifty states and the District of Columbia sponsor at least one type of 529 plan, and in some states privately-operated colleges and universities  also offer their own versions of the plan:t  the prepaid tuition plan and the college savings plan.

  • Pre-paid tuition plans generally allow the account holder (which can be the student or parents of the college student) to purchase units or credits at participating colleges and universities for future tuition. In some cases this also includes room and board. Most prepaid plans are sponsored by state governments and require that the student have legal residency. Many state governments guarantee their pre-paid tuition investment plans.
  • College savings plans generally permit a college saver to establish an account for a student for the purpose of paying the beneficiary’s eligible college expenses. They can typically choose among several investment options, such as stock mutual funds, bond mutual funds, or money market funds. Withdrawals from college savings plans can generally be used at any college or university. Funds put into plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.

The following chart  can be found on the United States Securities and Exchange Commission website, which outlines the distinctions between the two types of 529 savings plans:

 

Prepaid Tuition Plan College Savings Plan
Locks in tuition prices at eligible public and private colleges and universities. No lock on college costs.
All plans cover tuition and mandatory fees only. Some plans allow you to purchase a room & board option or use excess tuition credits for other qualified expenses. Covers all "qualified higher education expenses," including: tuition, room & board, mandatory fees, books, computers(if required).
Most plans set lump sum and installment payments prior to purchase based on age of beneficiary and number of years of college tuition purchased. Many plans have contribution limits in excess of $200,000.
Many state plans guaranteed or backed by state. No state guarantee. Most investment options are subject to market risk. Your investment may make no profit or even decline in value.
Most plans have age/grade limit for beneficiary. No age limits. Open to adults and children.
Most state plans require either owner or beneficiary of plan to be a state resident. No residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers.
Most plans have limited enrollment period. Enrollment open all year.

 

529 Tax Advantages & Limitations

Earnings in 529 plans are not subject to federal tax as long as you use the withdrawals for eligible college expenses. In most cases they are also exempt from state taxes.

Taking money out of a 529 plan and using it for another purpose will usually subject you to both income tax liability and an additional 10% federal penalty on earnings.

While states may offer tax breaks or other benefits, most states require that you invest in a plan sponsored by the state where you live in order to qualify. There are only a handful of states that will extend tax benefits to 529 savers regardless of where the 529 plan is established. That’s because these states are trying to boost enrollment in local colleges and universities, as opposed to encouraging residents to go to school out of state.

Read the Small Print

As with any kind of investment product, you should read the terms and conditions carefully and, if possible, review them with a qualified financial planner and tax advisor. Every 529 plan will have disclosure statements and program descriptions that break down and specify the investment options, tax benefits, potential penalties or fees, broker commissions, and other pertinent details.

The printed material that contains these disclosures is usually referred to as a “circular.” The Securities and Exchange Commission advises that you can find links to most 529 plans and their circulars on the  College Savings Plans Network, which is affiliated with  the National Association of State Treasurers.

Sometimes brokers will give you a discount if you invest above a certain minimum amount.There are also states that offer 529 plans that residents can invest in without paying a sales commission. You can generally find information about these direct-sold plans by contacting the plan’s sponsor, program manager or by visiting the plan’s website.

Beware Grandparent-Funded 529 Plans

Well-intentioned grandparents often set up a 529 plan to benefit a grandchild, but this strategy can backfire. That’s because income or assets that don’t come directly from the student or the student’s parents can make a student ineligible for valuable financial aid.

Colleges make their financial aid decision based primarily on the income and assets that parents and students list on the financial aid application of the “FAFSA” document.

Contributions to tuition from parents are not considered “student income” for the purpose of federal aid eligibility, but if  funds come from other relatives they are counted as “student income.”

The problems start when students who are ordinarily eligible for financial aid find that the 529 contributions made by grandparents raise their income level just enough to disqualify them. That could mean that help from grandparents or other extended relatives can spoil the student’s chance of receiving educational grants or subsidized federal loans.

While there are patchwork solutions to this dilemma, such as trying to transfer ownership of the 529 from grandparents to parents prior to distribution, they are not without flaws. Oftentimes the grandparent has to pay taxes or brokerage penalties, so it may be best to avoid grandparent-funded 529 plans altogether.

Some banks now have credit cards that earn rewards to put towards a 529 plan such as the Fidelity Investments 529 College Rewards Card. For more information about 529 plans, visit IRS.gov for a list of FAQ's.

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