Recently someone said to me that the only reason she invested in a 529 savings plan for her child was that everyone she knew had done the same thing. Often people have at best a vague understanding of how these plans work, why they are a desirable way to save for college, or how to select a plan that suits their needs.
I’ve found that most people don’t understand that there are actually two types of 529 plan. There are “prepaid” 529 plans and 529 “savings” plans; they differ significantly in some respects. In both types, state tax deductions may be available for contributions made to the plan. Qualified distributions from both kinds of plans are generally exempt from federal and state income taxes. All of the states, plus the District of Columbia, offer some type of 529 plan.
The owner of the plan and the beneficiary need not be the same person; most often a parent owns the plan and a child is the beneficiary. 529 plans generally permit the plan beneficiary to be changed from the original person to someone else who is a family member. The range of people who count as members of the family is wide; it includes not only the original beneficiary’s siblings, but also parents, first cousins, and others. Beneficiary changes should be done carefully, as there can be gift tax or even generation-skipping tax consequences associated with a beneficiary change.
Prepaid 529 Plans
A prepaid 529 plan involves a contractual agreement with a group of colleges (typically, they are public colleges, though there is one prepaid 529 plan for a group consisting of several hundred independent private colleges and universities) in which the owner arranges to pre-pay a child’s future tuition costs at today’s rates.
For several reasons, prepaid 529 plans are less popular than 529 savings plans. There are usually many more restrictions in prepaid plans. The beneficiary of the plan often must be a resident of the state sponsoring the plan, the plans are usually restricted to payment of undergraduate tuition and fees (no room and board, and no graduate school expenses), and the biggest negative is obvious: if the beneficiary cannot gain admission to a participating college or doesn’t want to attend one of the colleges in the group, the plan might not provide all the benefits anticipated. Prepaid tuition contracts usually permit the value of the contract to be transferred to out-of-state/private colleges, but you may not receive the full amount that would have been paid if the child had attended an in-state school.
A further risk of prepaid 529 plans is that they may not deliver as expected, even if the child attends an in-state public college. In 2002, the Colorado Prepaid Tuition Fund, hampered by a prolonged market downturn, could not deliver returns sufficient to keep up with college costs. The fund was closed and participants were limited to receiving a 5.5% return on invested funds rather than the 6-9% college inflation rate required to pay their expenses.
529 Savings Plans
A 529 savings plan typically offers a portfolio of mutual fund options into which contributions can be made. The plans are usually sponsored by states, and most states offer at least two 529 savings plans: a broker-sold plan and an “open” plan into which one can invest directly without an intermediary. Within both types of plans, there are usually several investment options. The fund options may be fixed to a specific asset allocation, or the investment allocation may be set to adjust based on the date of college entry, with the allocation shifting more and more toward cash and bonds as the start of college approaches.
As previously mentioned, some states offer state income tax incentives to in-state 529 plan contributors, but most state plans also permit nonresidents to invest in their plans. In fact, a growing number of states seem to be actively competing to attract the assets of out-of-state college savers. Several states have been revamping their plans to provide lower-cost options and more mutual fund choices. This is great news, as “first-generation” 529 plans often had unreasonably high cost structures. Now that some states are driving fees down, other state plans with higher fees should be motivated to revamp their plans.
As you can imagine, the large number of 529 savings plans (96 at last count) and the variety of investment options within each plan leave a would-be college saver with a bewildering array of choices. For example, if you live in a state that offers a tax break for residents who make contributions to one of its 529 plans, should you use your in-state plan even if the plan charges relatively high fund fees? Some research and analysis is needed in order to make a good decision. I’ll address the question of how to pick a plan in a future post.
Some 529 Plan Caveats
Although there is no federal limit on the amount of money that you can put into a 529 plan, many plans have rules that limit contributions. More importantly, the donor of a 529 plan contribution may incur gift tax liability if too much is contributed in a single year. Generally if you are planning to contribute more than $12,000 (in 2008) to an individual’s 529 plan (using gift splitting, a married couple may contribute $24,000), make sure you understand the gift tax consequences before making the contribution. It’s also possible to make five years’ worth of contributions in a single year, but again, before doing this make sure you understand the tax consequences of making a five-year gift.
Distributions from 529 plans must be used for qualified education expenses to avoid taxation. For 529 savings plans this means bills for tuition, room, and board. Funds distributed for any other purpose will cause the saver to owe income taxes (and possibly a 10% tax penalty) on the earnings distributed. This is true even if the funds are distributed in response to most types of hardship or emergency. If the beneficiary dies, most 529 plans permit a distribution to the beneficiary’s estate, with the earnings treated as taxable income but no penalty tax assessed. The penalty tax is also not assessed if the beneficiary becomes disabled or receives a scholarship for an amount equal to or greater than the distribution.
If the beneficiary simply decides not to attend college or the amount of money in the plan exceeds the cost of qualified expenses, distributions to the beneficiary are usually taxed to the beneficiary as income.
Obviously, 529 plans offer significant tax benefits for college savings. It’s important to plan appropriately so that they are used optimally. In particular, it’s wise not to over-fund a 529 plan; unless some other member of the family can use the money for qualified education expenses, the tax benefits of the plan are lost and you could even wind up paying a penalty.
Image by: Shreyes