529 plan is a college savings plan sponsored by a state or state agency to encourage saving for the future higher education expenses of a designated beneficiary. Such savings can be used for tuition, books, and other education-related expenses at most accredited two- and four-year colleges and universities, U.S. vocational-technical schools, and eligible foreign institutions. U.S. residents of any state, who are 18 years of age or older (or the age of majority in some states), may invest in most state plans.
It is named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996.
529 college savings plan originated from states rather than the federal government. With tuition cost increasing year by year, the state-run prepaid tuition program of Michigan addressed the increasing anxiety on the part of many thousands of Michigan households with the Michigan Education Trust (MET) proposition. This created a fund to which the state’s residents could pay a fixed amount in exchange for a promise that this state Trust would pay future tuition for a named beneficiary at any Michigan public college or university.
This provided an opportunity to prepay future tuition, which would not to be affected by future tuition increases. The initiative sparked interest in other states, which launched their first prepaid tuition program.
Congress has passed new legislation authorizing qualified state tuition programs. This is now part of the Small Business Job Protection Act of 1996. Section 529 was added to the Internal Revenue Code, conferring tax exemption to qualifying state programs and deferring tax on participant’s undistributed earnings.
Changes to the structure and marketing of 529 plans over the years have contributed to their growth. The states partnered up with the professional investment community, which allowed them to offer 529 plans with the feel of mutual funds. Also, registered brokers and investment advisors can directly assist families in understanding 529 plans and selecting an appropriate investment.
Other changes that have resulted in a growth in adoption include: federal legislation regarding taxes, financial aid, asset protection; on-going program improvement; lowering of expenses; generous state incentives; positive media coverage; and college savings registries that allow people sign up for the program. Some employers offer 529 plans to their employees as a benefit, similar to retirement plans, or even with contribution matching.
Advantages of 529 Plan
There are many advantages to the 529 plan. Some of them are mentioned below:
1. Tax Advantages
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. 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.
Many states give the account owner a full or partial state income tax deduction for their contributions to the state’s section 529 plans.
So far a total of 34 states and the District of Columbia offer such a deduction. California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, and New Jersey currently have state income taxes but do not offer a state income tax deduction or tax credit for contributions to the state’s 529 college savings plan.
Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, New Hampshire, Washington and Wyoming do not have state income taxes. Contributions to other states’ section 529 plans are generally not deductible in your home state. Only Pennsylvania, Arizona, Maine, Missouri and Kansas provide for state tax parity, where contributions to any state plan are eligible for the state’s income tax deduction.
2. 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, if a “non-qualified” withdrawal is made, the earnings portion will be subject to income tax and an additional 10% penalty tax.
3. Provides 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 of the 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.
4. It requires very low minimum to start up
529 plans generally have very low minimum start-up and contribution requirements. 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). Also there are no income limitations or age restrictions.
5. Assets are counted as part of the donor’s gross estate
529 plan can reclaimed by the donor (subject to income tax and the 10% additional penalty on any gains) the assets are not counted as part of the donor’s gross estate for estate tax purposes. Thus 529 plans can be used as an estate planning tool to move assets outside of one’s estate while still retaining some measure of control if the money is needed in the future. A beneficiary must be designated and the income tax savings are still only obtained if the money is eventually spent for education, though in some cases estate taxes can be reduced without spending the money on education.
Also under the College Cost Reduction and Access Act of 2007, 529 college savings plans and prepaid tuition plans are now treated as an asset of the account owner (typically the parent), meaning they have little impact on a student’s eligibility for financial aid.
6. Ability to transfer unused amounts
529 Plans offer the ability to transfer unused amounts to other qualified members of the beneficiary’s family without incurring any tax penalty. According to the IRS website (Publication 970), this type of transfer is known as a Rollover and is explained at length in their Qualified Tuition Program (QTP) section. Any amount paid to another QTP within 60 days of distribution is considered Rolled Over & does not require reporting anywhere on Form 1040 or 1040NR.
7. Offers investment options
The 529 plans managed by Fidelity offer a choice of investment options.The Age-Based Strategy invests in portfolios that automatically become more conservative as the beneficiary nears college age. Fidelity offers three types: Fidelity Funds, Fidelity Index, or Multi-Firm. The Custom Strategy allows you to allocate your assets among Static, Individual Fund, Age-Based, and Bank Deposit portfolios.
Disadvantages of 529 plans
While the number and types of 529 plans are growing, not all investment vehicles are available in 529 form. Unlike other types of tax-deferred plans, such as 401(k) plans, IRS rules allow two exchanges or reallocation of assets per year in a 529 plan.
The earnings portion of money withdrawn from a 529 plan that is not spent on eligible college expenses will be subject to income tax, an additional 10% federal tax penalty, and the possibility of a recapture of any state tax deductions or credits taken. For example, if you contribute $50,000 into a 529 plan and it grows to $60,000 over time and you make an unqualified withdrawal for the entire amount, you are taxed on the $10,000 gain plus a 10% penalty on the $10,000 which would be $1,000 penalty.
Paying tuition directly from a 529 account may reduce a student’s eligibility for need-based financial aid. Paying college expenses directly from a 529 account may reduce eligibility for the American Opportunity Tax Credit. To claim the full credit (in addition to meeting other criteria, such as income limits), $4,000 of college expenses per year should be paid from non-529 plan funds.
Because 529 plans are offered state by state, a person’s own state’s 529 plan may have much more expensive fees (expense ratios) than available alternatives. Also 529 plans are not required to disclose their expense ratios in marketing materials. That can be important because 529 fund option investment fees can range from under 0.4% to more than 1.1%. The difference can be significant: a family saving $2,000 each year for 18 years for their child’s college tuition. A 0.4% fee plan would cost them about $1,400 in total fees, while a 1.1% fee plan would cost over $4,000 in total fees. That’s an additional $2,600 in unnecessary costs.
The types of 529 plans
529 plans are usually categorized as either prepaid or savings plans.
Savings Plans work much like a 401K or IRA by investing your contributions in mutual funds or similar investments. The plan will offer you several investment options from which to choose. Your account will go up or down in value based on the performance of the particular option you select. You can see how each 529 plan’s investment options are performing by reviewing our quarterly 529 plan performance rankings.
Prepaid Plans let you pre-pay all or part of the costs of an in-state public college education. They may also be converted for use at private and out-of-state colleges. The Private College 529 Plan is a separate prepaid plan for private colleges.
Educational institutions can offer a 529 prepaid plan but not a 529 savings plan (the Private College 529 Plan is the only institution-sponsored 529 plan thus far).
Enrolling in a 529 plan
There are two ways to invest in a 529 plan. You can enroll directly with the 529 plan manager or through a financial advisory. People of all income levels can be enrolled; there are no income restrictions. Any U.S. resident who is 18 years or older, has a U.S. mailing and legal address, and a Social Security number or Tax ID
Anyone who has a Social Security number or Tax ID can be a beneficiary. A future college student of any age—the beneficiary can even be the same person who sets up the account.
Grandparents or others who wish to contribute to a child’s college savings plan may want to open a 529 plan account.
Gift Tax Considerations
Contributions to 529 plans are considered gifts under the federal gift tax regulations and hence any contributions in excess of $14,000 if filing single (or $70,000 over five years) or $28,000 if filing married jointly (or $140,000 over a five-year period) count against the one-time gift/estate tax exemption. The five-year period is known as the five-year carry-forward option: Once the single donor puts in $70,000 or the married jointly donor puts in $140,000, they are not able to make another contribution (gift) to that individual (without using part of their lifetime gifting exclusion) for five years.
Since tuition payments are not subject to the annual gift limitation, parents who are trying to minimize estate taxes may be better off making their annual gifts to another vehicle such as a Uniform Transfers to Minors Act (UTMA) account and then paying the tuition directly.
Selecting the right investment for 529 plans
When you enroll in a 529 college savings plan, you’ll need to select an investment portfolio from one of the choices offered by your plan. You’ll want to consider factors such as the age of your child and your tolerance for risk. 529 plans generally offer at least one of the following types of investment option:
- Age-based portfolios: The asset allocation of the portfolio will automatically adjust based on the child’s age over the life of the plan. In general, these portfolios shift away from riskier investments, such as equities (stocks), toward more conservative investments, such as bonds or money market funds, as the child gets closer to college; best for savers who prefer to “set it and forget it”.
- Static portfolios: The asset allocation of the portfolio is focused on achieving a specific investment objective. It will remain the same over the life of the plan, unless the plan owner chooses to manually reallocate to other portfolios; best for more experienced investors. Static portfolios include:Target risk portfolios – Focus on a defined level of risk or strategy, such as “aggressive growth” or “income” and Individual portfolios that mirror an underlying mutual fund, exchange-traded fund or other investment
Families who don’t want to worry about managing their investments will often choose an age-based option. Keep in mind, however, that the level of risk involved with an age-based portfolio can vary greatly. It’s important to understand the level of risk the portfolio will take on, e.g., conservative, moderate or aggressive, and match it against your risk tolerance and objectives.
Regardless of the type of investment you choose, be sure to pay attention to the costs. Fees and expenses can eat away at your investment returns and shrink your savings. Fortunately, many 529 plans have been reducing their fees and there are many low-cost options to choose from. It’s always a good idea to compare fees before deciding which 529 plan and investment portfolio to choose.