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It is never too early to start saving for college for your children!  529 plans are an excellent tax-advantaged investment tool to save for higher education expenses.  Here is a guide to introduce you to how they work.

What is a 529 Plan?

A 529 plan is a college savings plan named after Section 529 of the IRS tax code.  Contributions grow on a tax-deferred basis and withdrawals used for qualified education expenses of a designated beneficiary are tax-free!  529 plans are administered by state agencies and higher educational institutions, so there are many available across the USA.  There are two types of 529 plans:  prepaid tuition plans and savings plans.

Prepaid Tuition Plans

With prepaid tuition plans you purchase tuition at today’s rates with a payout to cover the future price of tuition.  The plan administrator, which can be a state or a financial institution, pools the assets and invests them to achieve returns sufficient to cover the cost.  Prepaid plans are currently offered in 12 states and cover tuition only.  Typically prepaid plans can only be used at in-state institutions, but not always; be sure to check with the plan to be sure.

Savings Plans

Savings plans are accounts where you choose the investments (generally mutual funds) in the plan according to your risk profile and growth is based on market performance.  Distributions can be used not just for tuition, but for additional qualified expenses such as room & board.   Savings plans are administered by states only and can be used for schools in any other state, provided the school is an “eligible educational institution”.

Tax Benefits

After-tax contributions to a 529 plan grow on a tax-deferred basis and qualified distributions are tax-free!  Additionally, while federal income deductions are not allowed for 529 contributions, many states allow state income tax deductions.  But the tax advantages don’t end there!  Contributions up to $13k ($26k if married filing jointly) during one year for a single beneficiary are exempt from the IRS gift tax.  Further, you can take five years of the exclusion in one year (barring you from using the exclusion again until the five year period is up).

Beneficiaries

You can designate anyone as beneficiary of a 529 plan, regardless of their relationship to the account owner.  You can even designate yourself as a beneficiary!  The only requirement is that the beneficiary be a US citizen or resident alien and that they have a social security number or federal tax ID.

If the beneficiary of a savings plan doesn’t end up going to college or receives a scholarship, you can change the beneficiary to a family member of the beneficiary, leave the savings in the account to continue to grow, or take a non-qualified distribution (earnings are then subject to taxation as well as a 10% penalty).  For prepaid plans, refund and transfer options are typically available but vary by plan.

Qualified distributions fall into the following categories:

  • Tuition, fees, books, supplies and equipment required for enrollment or attendance of a designated beneficiary at an eligible educational institution.
  • The cost of room and board for a designated beneficiary enrolled at least half time.
  • Expenses for special needs services that are incurred in connection with the enrollment or attendance of a special needs designated beneficiary at an eligible educational institution.

Non-qualified Distributions are any distribution that is not a qualified distribution.

Other Interesting Points

  • The assets in the account are not considered part of the donor’s estate so it is also a great estate planning tool!
  • Funds from one 529 plan can be rolled over into a different 529 plan one time per 12 month period.
  • Some states offer benefits such as matching grants to participate in their plan.
  • Generally, there are no income limitations or age restrictions.
  • With most plans, you can contribute as little as $15 and as much as $300k (although there is a maximum gift tax exclusion.)
  • If you’re interested in reviewing the top plans listed by state, Morningstar has a great listing of the top 529 plans here

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10 Lowest Cost 529 Plan Investments

  • New York’s 529 Plan (Direct) .25%
  • Utah Education Savings Plan .28%
  • Nevada Vanguard 529 College Savings Plan .28%
  • Ohio CollegeAdvantage 529 Savings Plan .29%
  • College Savings Iowa 529 Plan .34%
  • California ScholarShare College Savings Plan .37%
  • Michigan Education Savings Program .40%
  • Colorado CollegeInvest Direct Portfolio .42%
  • Virginia Education Savings Trust .42%
  • North Carolina National College Savings Program .45%

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10 Most Expensive 529 Plan Investments

  • South Dakota CollegeAccess 529 1.85%
  • Ohio BlackRock CollegeAdvantage 529 Plan 1.77%
  • Maine NextGen College Investing Plan 1.76%
  • Nebraska State Farm College Savings Plan 1.76%
  • Iowa Advisor 529 Plan 1.75%
  • NJ Franklin Templeton 529 College Savings Plan 1.74%
  • Alaska John Hancock Freedom 529 1.70%
  • New York 529 Program (Advisor) 1.70%
  • South Carolina Future Scholar 529 (Advisor) 1.69%
  • Nevada Columbia 529 Plan 1.68%

(Source: CBS News)

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What About College Savings Plans?  How are They Different?

(Source: SEC)

How to Open A 529 Plan?

Plans can be purchased directly from the state with lower fees, however, it is always prudent to seek professional advice and purchase the plan through your financial professional.  Fees are charged to pay standard sales commissions, however, a professional can advise you on what plan is right for you, as well as what level of contribution and investment risk profile is appropriate for your family.

Bottom Line

As with all investment plans, the goal here is to end up with more money in the account, therefore the expenses matter.  Pay close attention to the expenses associated with each plan and start there.

Sources:

  • Smart529.com
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