529 plan

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A 529 plan is a tax-advantaged investment vehicle in the United States designed to encourage saving for the future higher education expenses of a designated beneficiary.

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[edit] Overview

It is named after section 529 of the Internal Revenue Code. The detailed behavior of 529 plans is determined by state legislation, and while most plans allow investors from out of state, there can be significant state tax advantages and other benefits, such as matching grant and scholarship opportunities, protection from creditors and exemption from state financial aid calculations, for investors who invest in 529 plans within their state of residence.

There are two types of 529 plans: prepaid and savings.

  • Prepaid plans allow one to purchase tuition credits, at today's rates, to be used in the future. Therefore, performance is based upon tuition inflation.
  • Savings plans are different in that all growth is based upon market performance of the underlying investments, which typically consist of mutual funds. Most 529 savings plans offer a variety of age-based asset allocation options where the underlying investments become more conservative as the beneficiary gets closer to college-age. They also offer risk-based asset allocation options where the underlying investments maintain the same equity-to-fixed-income ratio regardless of the age of the beneficiary. Many savings plans also offer a stable value or guaranteed option designed to protect an investor's principal while providing for some investment growth, while others offer investments in certificates of deposit.

Prepaid plans may be administered by states or higher education institutions. Savings plans may only be administered by states. Although states administer savings plans, record-keeping and administrative services for many savings plans are usually delegated to a mutual fund company or other financial services company.

With the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), 529 plans gained their current prominence and tax advantages. Before EGTRRA, distributions from 529 plans for qualified higher education expenses were taxed at the beneficiary's federal income tax rate. After EGTRRA, distributions from 529 plans for qualified higher education expenses are exempt from federal income tax. The 529 plan provisions of EGTRRA, originally set to expire in 2010 due to a sunset provision, were made permanent by the Pension Protection Act of 2006.

[edit] Use for qualified education expenses

Money from a 529 plan can be used for tuition, fees, books, supplies and equipment required for study at any accredited college, university or vocational school in the United States and at some foreign universities.

The money can also be used for room and board, as long as the fund beneficiary is at least a half-time student. Off-campus housing costs are covered up to the allowance for room and board that the college includes in its cost of attendance for federal financial-aid purposes.

Qualified education expenses do not include student loans and student loan interest.

A distribution from a 529 plan that is not used for the above qualified educational expenses is subject to income tax and an additional 10% early-distribution penalty unless one of the following conditions is satisfied:

  • The designated beneficiary dies, and the distribution goes to another beneficiary or to the estate of the designated beneficiary.
  • The designated beneficiary becomes disabled. A person is considered disabled if there is proof that he or she cannot do any substantial gainful activity because of a physical or mental condition. A physician must determine that the individual's condition can be expected to result in death or continue indefinitely.
  • The designated beneficiary receives any of the following:
    • a qualified scholarship excludable from gross income
    • veterans' educational assistance
    • employer-provided educational assistance
    • any other nontaxable payments (other than gifts, bequests or inheritances) received for education expenses
  • The distribution is included in income only because the qualified education expenses were taken into account in determining the 'Hope Credit' or 'Lifetime Learning Credit', both of which are tax credits that reduce the amount of the taxable income of an individual funding a student's education.
  • The distribution is made before 2007 and used for qualified higher-education expenses but included in income because it was paid from a 529 plan established and maintained by an eligible educational institution [1]

[edit] Advantages

There are many advantages to the 529 plan:

First, although contributions are not deductible from the donor's federal income tax liability, many states provide state income tax deductions for all or part of the contributions of the donor. For example, under Missouri's MOST Program, donors may deduct up to $8,000 in the aggregate for contributions to all accounts of the donor in any taxable year. [2] Beyond the potential state income tax deduction possibilities, a prime benefit of the 529 plan is that the principal grows tax-deferred and distributions for the beneficiary's college costs are exempt from tax. This latter feature was made permanent with the Pension Protection Act of 2006. In some states, contributions are deductible to the donor.

Second, the donor maintains control of the account. With few exceptions, the named beneficiary has no rights to the funds. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the "non-qualified" withdrawal will be subject to income tax and an additional 10% penalty tax). Compare this level of control to a custodial account under the Uniform Transfers to Minors Acts (UTMA).

Third, a 529 plan can provide a very easy hands-off way to save for college. Once one decides which 529 plan to use, one completes a simple enrollment form and makes a contribution (or signs up for automatic deposits). The ongoing investment of the account is handled by the plan, not by the donor. Plan assets are professionally managed either by the state treasurer's office or by an outside investment company hired as the program manager. The donor will not receive a Form 1099 to report taxable or nontaxable earnings until the year you make withdrawals. If an investment switch is desired, donors may change to a different option in a 529 savings program every year (program permitting) or the account may be rolled over to a different state's program provided no such rollover for the beneficiary has occurred in the prior 12 months. There is no federal limit on the frequency of these changes if the account beneficiary is replaced with another qualifying family member at the same time.

529 plans generally have very low minimum start-up requirements and low contributions. The fees, compared with other investment vehicles, are low, although this depends on the state administering the plan.

Finally, everyone is eligible to take advantage of a 529 plan, and the amounts that can be put in are substantial (over $300,000 per beneficiary in many state plans). Generally, there are no income limitations or age restrictions.

[edit] Disadvantages

An article in Slate magazine showed the high fees that can be associated with these plans may make them less effective saving tools than more traditional funds.[1] A more recent analysis concluded that while some 529 plans have improved by reducing fees and expenses and offering more investment options, others still charge exorbitant fees that effectively negate the plan's tax benefits[2]. For example, one of Louisiana's plans charged a very modest $19 over 10 years, while one of Montana's 529 plans managed by Pacific Life charged as much as 35% of the buyer's original investment over a 10 year period.

While the number and types of 529 plans is growing, not all investment vehicles are available in 529 form.

The earnings portion of money withdrawn from a 529 plan that is not spent on eligible college expenses will be subject to income tax and an additional 10% federal tax penalty.

The 529 account is counted as an asset that may affect the eligibility of financial aid (loans and grants). A potential workaround for this is for the plan owner to be someone other than the student or their parent.

[edit] Other considerations

Contributions to 529 plans are considered gifts under the federal gift tax regulations and hence (as of 2008) any contributions in excess of $12,000 (or $60,000 over five years) per donor is counts against the one-time gift/estate tax exemption.

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