What is a 529 Plan?

Known formally as “qualified tuition plans”, 529 plans are tax-advantaged savings plans created to encourage saving for the future cost of a college education. They are named after section 529 of the Internal Revenue Code, created in 1996. 529 Plans can be sponsored by state governments and state agencies, or directly by educational institutions. As such, there is a wide variety of options and features that vary from state to state and depending on which type of plan is being offered.

Two Types of 529 Plans

There are two principle types of 529 Plans and then variations within these two types. The two types are, 1) 529 College Savings Plans, and, 2) 529 Prepaid Tuition Plans. College savings plans are offered by states and state agencies, and at present, all 50 states plus the District of Columbia, sponsor at least one type of 529 college savings plan. Prepaid tuition plans are offered directly by colleges and universities, and a few states.

A Quick Summary of the Primary Differences:

• College Savings Plans operate similar to tax-deferred IRA and 401(k) accounts. Though, for most states, there is no tax-deduction for the contributions made to the account, the contributions are invested in assets such as mutual funds, stocks and bonds, and the earnings and principle grow tax-deferred. Qualified distributions (discussed below) are exempt from taxes. The risk and reward of the college savings plan lies in the performance of the underlying investments.
• Prepaid Tuition Plans are designed to pre-purchase tuition credits, and in some cases room and board, usually at or near today’s cost of tuition, in effect “locking in” costs at eligible public and private colleges and universities. Unlike the college savings plan, contributions are not held in an investment account in the contributor’s name and subject to the ebb and flow or the markets. The risk and reward of the prepaid tuition plan lies in the assumption that the cost of tuition (and room and board when appropriate) will be much higher at the time the beneficiary of the plan enters college.

There are other important differences between these two types of 529 plans, discussed below.

Details of the 529 College Savings Plan

College savings plans, prior to the “529” designation, were originally created within the states. It was only later, after their success and some disputes between some states and the federal government over tax issues, that the federal government created the 529 Plan to create some uniformity and clarity to the plans as to the way they were to be treated from a federal taxation position. However, many details and features of the plans vary from state to state, and some states offer more than one plan. As such, requirements and features are too varied to discuss in detail in this article. We will endeavor to highlight the most important characteristics of the 529 college savings plan below. You are always advised to seek professional assistance before selecting the plan best suited to your situation.

Do I Have to Chose a Plan from the State that I Live In?

You are not required to invest in a plan from your state of residence. Further, the student beneficiary is not limited only to schools within their state of residence. It is important to first consider plans offered from your state, especially if you live in a state with state income taxes, because your state may be able to offer tax benefits that other states can’t offer. However, you may live in one state, invest in a plan provided by a different state, and the student may attend a college or university in yet another state.

What are the Contribution Limits for the 529 Savings Plan?

First off, anyone can contribute to a 529 savings plan. There is no income limitation restricting those with high annual incomes from making a contribution.

Contribution limits are set by each state and they can be substantial. Some states allow, for example, over $300,000 in contributions per beneficiary. Many states allow more than $200,000 per beneficiary. 529 Savings Plans are a great way to set aside very large amounts of money for college education expenses.

However, contributions may be deemed “gifts” and be subject to annual and lifetime gifting rules and taxation.  Consult a tax advisor and discuss with your financial advisor.  Certain strategies may help limit the impact of these gifting rules.

What College Expenses are Covered by the Plan?

Most often, the 529 Savings Plan covers more expenses that the 529 Prepaid Tuition Plan. Qualified higher education expenses for the 529 Savings Plan include tuition, room and board, mandatory fees, books and computer (if required). Off-campus housing may also be covered if the student is at least half-time and meets the plan’s other qualification requirements. The prepaid tuition plans are usually limited to only tuition and mandatory fees. Some plans may allow for the purchase of a room and board option and some plans may allow excess tuition credits to be applied toward other qualified expenses.

Who Qualifies as the Student Beneficiary?

There are no age limits for the 529 Savings Plan. It is open to adults and children.

Are there State Guarantees Against Investment Losses?

There are no state guarantees with the 529 Savings Plan. Investments inside the plan are subject to market risk, meaning that they can earn a profit, no profit or even decline in value. In contrast, many of 529 Prepaid Tuition Plans are guaranteed by the state.

What Types of Investments are Available?

Investment options vary widely from state to state and plan to plan. In some cases, investments are managed by the state’s treasury department and in other cases by an outside investment management firm. Similar to employer-sponsored 401(k) plans, the account holder may be provided a limited number of investment choices, such as a number of different stock mutual funds, bond mutual fund and money market funds. Also, there may be aged-based portfolios that automatically shift toward more conservative investments as the student approaches college age. At present, changing the investment option within 529 Savings Plans is limited to once per year. Consult the details of each plan or seek advice from an independent financial advisor to determine the most appropriate course of action for your specific needs.

What Effect Does a 529 Savings Plan have on Financial Aid Eligibility?

Whether the parent is the holder of the 529 Savings Plan, or the student, the end result is the same,—assets contain in a 529 Savings Plan are treated as “parental assets” for the purpose of the federal financial aid application (FAFSA). As such, parental assets are assessed at a maximum 5.64% rate in determining the student’s Expected Family Contribution (EFC).

Another consideration related to financial aid eligibility concerns how 529 distributions are treated when calculating the student’s “base-year income”, a number that effects how much aid a student may receive. Treatment is favorable. A qualified, tax-free distribution from a 529 plan to pay the current year’s college expenses will not be part of the “base-year income” that reduces next year’s financial aid eligibility.

Finally, the above only relates to federal financial aid rules. Each school will have it’s own set of criteria when determining eligibility for its own needs-based scholarships and financial aid packages. Schools have already begun to adjust awards when they discover the presence of 529 accounts for the student. Also, remember that many aid programs come in the form of loans and not grants, such that you’ll end up paying it back with interest eventually.

How Does a 529 Savings Plan Affect Federal and State Income Taxes?

In most cases, contributions receive no beneficial tax treatment, but earnings on plan assets grow untaxed within the account and when withdrawn properly for eligible college expenses remain untaxed. Some states have begun to offer some form of tax-deductibility for contributions made by those who are also state residence. It is important to study the details of each plan to know if your state offers this benefit.

Differences and exceptions exist from state to state, which makes it important to study the rules for each state and to seek professional guidance when making decisions. Some states may only offer tax benefits to participants who are also residents of that state. Some states have begun to allow tax benefits to state residents for out-of-state 529 plans. Some states even offer matching grants to state residents who participate in an in-state 529 plan.

It is important to always consult to detail of a state’s plan before making changes, such as rolling over a plan into a different in-state plan, or to a plan in a different state. Some transactions could trigger significant tax consequences.

What Happens with Unused Money from a 529 Savings Plan?

It is important to note that unqualified withdrawals trigger unfavorable tax consequences. Because contributions received no favorable tax consequences in the year they were made, they can be withdrawn penalty and tax free in most cases. The concern is with the investment earnings within the plan that has yet to be taxed. Unqualified earnings withdrawals will normally trigger a 10% penalty (federal law) and be taxed as ordinary income (as opposed to the usual capital gains tax rate). Each state may also have a penalty or tax for unqualified withdrawals.

With unused money, there are a couple of situations to consider. In the unfortunately death or disability of the student, earnings can be taken out penalty-free, but will still be taxed as ordinary income. This may also be the case if the student receives a scholarship covering the cost of education.

Finally, in the event of unused or excess money, the beneficiary of the account can be changed to another qualifying family member, and the funds used in the future for qualifying education expenses for the other family member.

Most offer a quid-pro-quo ability to remove like amounts to those of a scholarship received,without penalty.

Details of the 529 Prepaid Tuition Plans

As mentioned above, prepaid tuition plans are usually offered by colleges and universities. The college or university determines the contribution amounts for its specific program. Likely, a lump sum amount is offered as well as an installment payment program. The benefit to the prepaid tuition plan is that contributions are not invested within the plan and, as such, are not susceptible to the ebb and flow of investment markets. If payments are made according to the plan, the student will receive the benefits defined by the plan.

What Education Expenses are Covered?

Most often, the 529 prepaid tuition plan covers only tuition and mandatory fees. Some institutions offer an option for room and board.

Are There Contribution Limits?

Because this plan outlines the exact amount of contributions to be made to meet the requirements of the plan, it doesn’t have contribution limits set in the same way as the 529 Savings Plan.

Who Qualifies as the Student Beneficiary?

Unlike the 529 Savings Plan, which is open to students of all ages, the 529 Prepaid tuition plans have age and grade limitations for the student beneficiary. It is important to consult the requirements of each plan to know the details.

What Effect Does a 529 Prepaid Tuition Plan have on Financial Aid Eligibility?

Unlike the 529 Saving Plan, contributions made to a 529 Prepaid Tuition plan reduce financial aid eligibility dollar for dollar.

Many Prepaid Tuition Plans are backed by the State

Unlike the 529 Savings Plan, where the risk lies principally with the investment yields, the risk of the 529 prepaid tuition plan lies in the ability of the college or university to meet its end of the deal in the future when the student is ready to attend school. In some, though not all states, prepaid tuition plans are guaranteed or backed by the state. As always, consult the details of each plan carefully.

Am I Locked into Attending the Plan’s College or University?

Some states offering prepaid tuition plans will allow you to transfer the value of your contract to private and out-of-state schools. In some cases, you may not get full value in the transfer. With prepaid tuition plans offered directly by the college or university, transfers to another school are less likely, and you must consult the plan’s details to learn if a transfer is possible. Some plans already include a choice from a group of institutions, rather than just one school.

Is Investing in a 529 Plan Right for Me?

There are many factors to consider, not only in the options available for education savings plans, but also for other important financial matters you may face, such as saving for retirement, buying a home, paying off high-interest debt, starting a business and so on. Decisions related to saving for education are best made as part of a comprehensive financial plan created by a qualified professional, such as an independent financial advisor.

Benefits to Estate Planning for Parents and Grandparents?

It is interesting to note that funds in 529 Plans are not considered part of the donors estate for determining Estate Taxation, yet at the same time the donor can retain control of the funds investment, disbursement and beneficiaries.  As far as I know, this is the only vehicle that can claim this unique feature.  For these reasons, 529 Plans have been popular as Estate Planning vehicles as well college funding.  Consult your advisors to see if your circumstances warrant a closer look.

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About the Author

Todd E. Frank, CPA/PFS, MBA is the President and CEO of Frank Financial Advisors, a Registered Investment Advisory Firm (RIA) serving clients nationwide from our headquarters in Carlsbad, San Diego, California. As an RIA, Frank Financial Advisors is able to offer truly independent, fee-only financial advisory services.