Congress created 529 College Savings Plans in 1996 with the purpose of providing tax advantages and other incentives to make it easier to save for college and higher-education expenses. The commonly used name ‘529 College Savings Accounts’ comes from the section in the tax code outlining the plan, but the legal name for these types of savings vehicles is a Qualified Tuition Program.
There are two basic types of 529 plans: prepaid tuition and savings plans. Each state has its own plan and has the ability to offer one or both options. As we’ll explain in more detail, each state also has the ability to customize their 529 plan to a certain degree, which is why it’s so important to research the best 529 plan for you.
Prepaid Tuition Option
With this option, you can lock in today’s tuition rates that can apply towards any of the eligible state colleges or universities your child attends in the future. If your child chooses to attend an out of state school (including private colleges), the plan will also pay out an equal amount of money.
The prepaid option is usually set up directly with a state agency that allows you to buy a tuition unit, which translates into one year of tuition. Your options for payments are a one-time lump sum payment or monthly installments.
The state offers this options because they invest the prepaid tuition dollars in order to meet the future increase in tuition.
One consideration that must be made with respect to the prepaid option is that the money paid out of the prepaid 529 plans will offset financial aid eligibility. For example: if your prepaid 529 tuition plan paid $15,000 for tuition one year, your child will be seen as needing $15,000 less in financial aid.
529 Savings Option
Save money in a tax deferred account (earning only) that can be used to pay for education at future tuition rates. The purpose behind the savings option is to allow your contribution to grow to meet the rising cost of future college tuition. This option does not lock in the costs to attend any state school. The funds within the plan are eligible to be used towards all qualified higher-education expenses including tuition, room and board, school fees, books and computers.
States offering the 529 savings option generally do not require residency within that state and generally allow investors to open an account at any time throughout the year.
529 Plans By State
Each state sets up their own 529 College Savings Plan with an asset management company of their choice. You are able to open a 529 savings account under the state’s plan and you deal directly with the investment company managing the state’s plan. In other words, if the state uses Vanguard 529 College Savings Plan management team, your statements will say Vanguard and you’ll work with that company if you have questions on your account.
Many states do not require that you are a resident of that state in order to participate in their 529 plan. This is important because some states have different features that make their plan a little more attractive. While every state is required to maintain the same overall framework and maintain the basic federal guidelines for 529 plans, they are free to make some changes to customize their plan.
Tax Benefits of a 529 Savings Plan
Earnings are Tax Exempt
When used for qualified education expenses, the earnings within your 529 college savings account will be exempt from taxes. Normally, an investor would be required to pay taxes on earning from stock investments, but with a 529 plan, the investor receives a tax break and does not have to pay taxes on the earnings when used for educational expenses. (See below)
Contribution May Be Deductible in Certain States
While your contributions cannot be made as pre-tax, you may be able to deduct a portion of your contribution from your state taxes depending on which state you live in.
529 College Savings Plan Features
Unlike other college savings vehicles like the Education Savings Account or Coverdell IRA, 529 plans remain controlled by the account owner and not the student. Other plans often grant control to the beneficiary at age 18 or 21, but with the 529 plan, the control is maintained by the account owner (parent, grandparent, or guardian). This helps in easing the minds of diligent saving account holders who might be afraid that their child would ditch college to backpack through Europe with the money saved.
You can also open an account for anyone, including yourself. The beneficiary you choose does not have to be related to you and contribution can be made by anyone. That means your grandparents, neighbors, teachers, and friends can make contribution to your 529 plan.
Income Eligibility for 529 Plans
Unlike ESAs (Educational Savings Accounts) which set a maximum income limit of $110,000, 529 plans do not have an income limit with respect to eligibility. Anyone can open and contribution to a 529 college savings plan regardless of income level. Some states set requirements on how large your account can be, so make sure you look at your state’s 529 plan requirements so that you understand the maximum amount allowed.
Using the Money Within the 529 Plan
Most states do not place an age or time limit for when the funds need to be used. The money can grow until the beneficiary is ready to attend school at age 50 if they choose. You can also choose to roll the account over to another child that is in the same family of the first beneficiary.
The definition of family is considered as “the original beneficiary’s spouse, children, sisters, brothers, nephews, nieces, first cousins, and any spouses of those persons.”
Qualified Expenses and Education Costs
The money within your 529 college savings plan can go towards any accredited degree-granting educational institution, including public, private, and both 2-year and 4-year schools. Most states will allow for the funds to be applied towards: tuition, books, room and board, transportation, and even computers.
Investing Within Your 529 College Savings Account
Most states use familiar investing companies such as TIAA-CREF, Vanguard, or Fidelity. The money within your 529 account is invested as you choose, within the investment options provided by the financial company managing the plan. Once you’ve selected an investment option, you must keep that option and cannot change your selection. You do have the ability to roll your money into another state’s plan if you are unhappy with your investment selection, but you can only do this once every 12 months.
Most plans offer a target date strategy that determines the investment allocation based on the beneficiary’s age. For example: if your child is two years old, the account would be more aggressive today and eventually shift from stocks to bonds as the child nears college age.
Drawbacks to the 529 College Savings Plan
While there are great benefits to using a 529 College Savings Plan, there are some drawbacks that need to be taken into consideration.
Financial Aid Eligibility
Distribution from a 529 plan may affect your child or beneficiary when it comes to financial aid. The 529 account is considered to be an asset of the parent or account holder, so when assessing the parent’s ability to contribute towards the child’s college cost (calculated through FAFSA), the value of your 529 account will be considered. The expected contribution of an account holder will include up to 5.6% of the value of the 529 plan, which is actually better than the 35% that is assessed on money that is in the child’s name.
Which 529 Plan Should I Choose?
Like any financial vehicle, a smart investor will research the best options available to him or her. Take your time to look through the plans of different states and follow these general guidelines for selecting the best 529 College Savings Account.
Start With Your Own State
Many states will allow residents to claim a state tax deduction on 529 plan contributions. Furthermore, many states will exempt state tax on the earnings when withdrawn from the account.
Research the Account Manager
Most states will use a respected financial institution like TIAA-CREF, Vanguard or Fidelity, but it’s wise to research which one provides the options that suit you best. You want to look at the investment options and study the past returns of the mutual funds provided within the plan. Consider this as you compare plans to each other.
Understand the Fee Structure
Investment firms charge fees to use their mutual funds and investments. Try to find a plan that gives you the most flexibility and tax benefits but also has low fees tied to it. Be on the lookout for these costs:
- Enrollment fee to open account
- Annual maintenance fee
- Expense ratio (mutual fund fees)
You can expect to pay mutual fund fees in the range of 0.31 percent to 2 percent or more for a 529 plan.
Assess the Plans Flexibility
Does the state plan have age restrictions or charge penalties for rolling funds to another beneficiary? How does the state view the use of funds towards graduate schools? You want to make sure that you choose a 529 plan that has flexible options for you and your students.
Also, some states will charge more for unqualified withdrawals made to the account. In addition to the federal fee of 10%, your state’s plan may assess a higher penalty or even close out the account entirely if you use fund prematurely or for non-educational purposes.
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