It is no secret that the cost of college tuition is rapidly outpacing the cost of living. Therefore, it is essential for parents to map out a targeted strategy for saving and investing money for their children’s higher education as early as possible. When it comes to saving for college, there are two popular plans: 529 Plans and the Coverdell Education Savings Account (formerly known as the Education IRA). Let’s get an overview of 529 Plans in greater detail.
1. What are 529 Plans?
Named after Section 529 of the Internal Revenue Code, a 529 Plan is a federally tax-advantaged education savings vehicle. Although 529 Plans are usually state-sponsored, they can also be sponsored by educational institutions. A 529 Plan is often referred to as a Qualified Tuition Plan (QTP).
2. Is there more than one type of 529 Plan?
There are two types of plans: prepaid tuition and savings. A prepaid tuition plan which is also referred to as a guaranteed savings plan allows a donor(s) to effectively lock in the current tuition rate of a college or university by purchasing the tuition at the present day prices. Note: the plan does not guarantee admission into college.
Advantage of Prepaid Tuition Plans:
• Comparatively low risk.
• Can be used as a hedge against inflation.
• May be advantageous to those students who are 3 to 6 years away from college.
• The plans are generally limited to an in-state college or university, or in some cases, participating private colleges and universities. Refer to the Independent 529 Plan.
• Limited coverage. The funds may be restricted to tuition only, leaving out room and board and miscellaneous expenses.
• May be subject to state residency requirements.
• May be an obstacle to beneficiary being eligible for financial aid.
• High penalties can be levied in the event of cancellation of the plan.
Every state and the District of Columbia has at least one type of 529 Plan and many states offer both the prepaid tuition plan and the savings plan. However, it cannot be more strongly emphasized that 529 Plans are complex and can vary tremendously from state to state. Individuals considering 529 Plans for college funding need to consult with an experienced financial advisor who can help them select and establish an appropriate plan.
3. What are some of the advantages associated with 529 Plans?
• Although larger contributions (contribution limits vary with state) can be made, it is crucial to note that the amount of contributions allowed are only those that are deemed necessary to cover the educational expense for the beneficiary.
• Anyone can open a 529 Plan. Some plans will even allow you to set up a 529 savings account for yourself if you plan on going back to college.
• Currently, one can make contributions to the 529 account and a Coverdell Education Savings Account during the same calendar year for the same beneficiary.
• Depending on the particular state, donors may be eligible to receive tax breaks. For low-income families, some states offer matching contributions.
• Gift tax exemption.
• Since 529 Plans are considered “parental assets” they do not hinder the ability of the beneficiary to receive financial aid. Currently, parental assets are assessed at the maximum rate of 5.64% for Expected Family Contribution (EFC).
• Some plans allow the option of transferring the 529 Savings Plan to another designated eligible beneficiary.
• The account holder is the owner of the 529 Plan, not the beneficiary.
• Estate planning tax advantages.
4. How are withdrawals from 529 Plans taxed?
Withdrawals from the plan are exempt from federal taxes so long as they are used to cover all qualified college expenses. Special note: if the money is withdrawn and not used for qualified higher education expenses, an additional 10% tax penalty will be levied on the earnings in addition to ordinary income tax.
QUICK COMPARISON OF PREPAID TUITION PLAN AND SAVINGS PLAN
|One can “lock” in the current rate of tuition of participating state and private colleges and universities by purchasing the tuition for future use. You can purchase all or part of the tuition - units or contract. Payment can be lump-sum or in monthly installments. For example,one can purchase a semester of tuition or even 5 years worth of tuition.||Does not offer a “lock” on tuition rate.|
It is a tax-exempt investment account. Similar in this respect to an IRA.
|The plan can be guaranteed by the state (although this can vary).||No guarantee. The plan is subject to market risk, i.e., loss of principal and/or interest.|
|Age or grade restrictions for the beneficiary may apply.||No restrictions on age of either beneficiary or donor.|
No income limitations on donor.
|State residency requirements may apply to the donor and/or beneficiary.||Donors are not subject to state residency requirements.|
|Plans may be subject to a limited enrollment period. Management and/or maintenance fees may be assessed.||May incur enrollment fees in addition to investment maintenance and management fees. Funds purchased through a broker may involve “front-end and back-end loads”. “Load” and even some “no-load” funds may also charge a 12b-1 fee. Fund transfer or rollover may be restricted to once yearly.|