Consumer Focus: The 529 Plan and How It Works This is an archived document.
The 529 Plan and How It Works
It’s not often we can make a major purchase now and enjoy a huge savings on it later. With the 529 plan, anyone at any income level can put aside money tax-free for a child or even himself for college. States and colleges offer different plans, so it helps to have an idea of the location or school you prefer before you explore the 529 plan options available in each.
There are two types of 529 plans: college savings plans and prepaid tuition plans. They may be sponsored by states, state agencies, or educational institutions. Both are named after section 529 of the Internal Revenue Code that authorized these entities to provide:
college savings plans allowing consumers to set aside tax-free funds for college tuition, and
prepaid tuition plans enabling parents to lock in tuition at current state guaranteed rates.
Common Features of College Savings & Prepaid Tuition Plans
Both plans offer federal tax advantages. The earnings grow tax-free and the withdrawals are tax-free when used for qualified education expenses. Note that the qualified expenses differ between the plans.
States also offer tax advantages for both types of 529 plans. Check with your state’s plans to learn more about the benefits that apply in your area.
529 plans allow the account owner to maintain control over the assets for the life of the account.
The assets of one 529 plan can be transferred tax-free to another 529 plan of another beneficiary, as long as the new beneficiary is a family member of the original beneficiary.
If you withdraw money from either type of 529 plan, and that money does not get used for qualified education expenses, you will have to pay penalties.
College savings plans offer a wide range of benefits - these plans allow students of all ages to save for college costs. Here are some ways in which the college savings plans differ from prepaid tuition plans:
College savings plans do not lock in college costs; they simply provide you with a savings vehicle to use specifically for educational expenses.
Covered education expenses include: tuition, mandatory fees, room and board, books, and equipment, such as computers.
Many plans have contribution limits in excess of $200,000.
The plans do not have a guaranteed profit and are subject to ups and downs of the market.
College savings plans are open to children and adults.
There are no residency requirements so you can purchase a plan from a state where you are not a resident.
You can enroll in a college savings plan year-round.
Prepaid tuition plans offer a wide range of benefits, including no risk to principal, a better rate of return than bank savings accounts and CDs, and they are often guaranteed by the state. The ways Prepaid Tuition Plans differ from College Savings Plans include:
Prepaid tuition plans lock in tuition prices at eligible public and private colleges and universities.
Covered education expenses include tuition and mandatory fees only. Some plans offer an option to include room and board or other qualified expenses.
Prepaid tuition plans establish contribution limits by setting up a contract to pay for tuition at a two-year community college, four-year undergraduate program, or a combination of the two. Some plans also include an option for graduate school.
(2) The account owner, not the beneficiary, maintains control of the account and has control over when withdrawals are made and for what purpose. While owners may reclaim their initial investment at any time, penalties are stiff.
(4) Anyone, regardless of income or age restrictions, may participate in a 529 plan, often for as little as $25.00. The ceilings for maximum lifetime contributions, on the other hand, can be as high as $290,000.
Complexity: Since they are not federally regulated, 529 plans vary widely. Currently, 70 plans exist among the 50 states and the District of Columbia. Each plan has different rules and offers unique investments and pricing.
Investment choice limitations: States may offer several discreet funds, grouped by type, such as money market; equity mutual funds comprised of international stocks and blue chip stocks; the U.S. Bond Index fund, or a mix of stocks and securities. The plan owner may choose the general type of investment plan, but not the individual stocks or funds within it.
Penalties for early withdrawal: If you want to withdraw your money for non-educational purposes, or before say, two to three years after the initial investment, expect to pay heavy penalties—a 10% penalty to the federal government and the state, in some cases—in addition to federal taxes.
Fees: Each type of plan carries unique fees; when you are ready to decide on a plan use an online tool to help narrow the field.
Choosing a broker: Trust and track record are two of the major issues in choosing a broker. Fortunately, non-biased sources are available to rate both online.
Income tax laws are a work in progress. The current statute regarding 529 plans expires in 2010, and there are no guarantees what Congress will decide to do afterward. Keep the following tips in mind when choosing a 529 plan.
Diversification will offer a hedge against changes in tax law.
The Coverdell Educational Savings Account, an alternative to 529 plans, also offers tax-deferred savings potential, and will not face expiration in 2010.
The public, accustomed to this form of saving for education, may demand the 529 plan be extended, but subject to federal regulation to reduce increasing fees and complexity among the states.
Be on the lookout for 529 plans to be “in the news” as 2010 approaches.
* Names of resources and organizations
included in this online article are provided as examples only,
and their inclusion does not mean that they are endorsed by
the Federal Citizen Information Center or any other Government
agency. Also, if a particular resource or organization is not
mentioned, this does not mean or imply that it is unsatisfactory.
*If you click
on these links, you are leaving FCIC's website. Please bookmark
us before you leave so you can return easily. FCIC is not responsible
for the content of these websites.
