College funding

Is a 529 plan the right solution for me?

Aug 09, 2011

Each year, the cost of earning a college degree rises a little higher. What can you do to keep up?

According to The College Board, total annual charges for tuition, fees, and room and board for full-time college students have topped $12,700 at the average four-year public university and $30,300 at the average four-year private college.

That’s a daunting figure even if you have a plan for how to fund it. If your children are still young, evaluate your options and begin saving early so your money has plenty of time to grow. For many families, a Section 529 qualified College Savings Plan could be a good option.

There are two types of 529 plans:

  • State savings plan
  • Prepaid tuition plan

Both are governed under Section 529 of the Internal Revenue Code, but they are very different savings vehicles.

A state savings plan is a tax-advantaged college savings vehicle that lets you save money for college in an individual investment account. Some plans let you enroll directly, while others require that you go through a financial professional.

A prepaid tuition plan is a tax-advantaged college savings vehicle that lets you prepay tuition expenses now for use in the future.

Prepaid tuition plans can be run either by states or colleges. For state-run plans, you prepay tuition at one or more state colleges; for college-run plans, you prepay tuition at the participating college. Pre-purchased tuition credits are typically guaranteed to be worth a certain value in the future, no matter how much college costs may increase.

Your contributions are pooled together with those of other participants into a general fund, and the money is invested. Contributions grow tax deferred, which means you don't pay income tax on the account's earnings each year. Money you withdraw to pay for college expenses (a qualified withdrawal) is tax free at the federal level.

One major disadvantage of the prepaid tuition plan is that your child is limited to the participating colleges—if your child attends a different college, plans differ on how much money you'll get back. Also, if the plan earns more than the relevant college inflation rate, you're not necessarily entitled to the difference. There may be enrollment and maintenance fees, and money in a prepaid plan is treated less favorably than money in a state savings plan for purposes of federal financial aid.

A 529 state savings plan is easy to open and flexible since a third party, such as an investment firm, manages the proceeds. Everyone is eligible because there are no income or age restrictions, and many plans have initial contribution amounts of less than $100. The proceeds can go towards any accredited educational institution in any state, whether it’s public, private, two-year or four-year.

You aren’t required to invest in a plan offered by your state of residence, but do your research because each state determines its own lifetime contribution limit with some exceeding $300,000 per beneficiary.

Proceeds from state savings plans have a limited impact on the student’s financial aid since assets are the property of the owner, not the beneficiary. Often, money in the student’s name has a larger impact on financial aid than money in the parent’s name.

In addition, beneficiaries do not gain control of the money when they reach the age of majority (18 or 21 depending on where you live). Thus, if the beneficiary of a 529 plan decides not to attend college, the account proceeds may be used to fund another family member’s college expenses.

Among drawbacks, state savings plan investment choices are limited to mutual fund-type investments. You can’t choose individual stocks, bonds or other investments, nor can you contribute these to a 529 plan without first liquidating them because only cash contributions are accepted.

Plan changes are limited to once every 12 months, including transferring your account to another state’s plan.

Earnings in state savings plans also grow tax free and distributions are tax free as long as the proceeds are used for qualified higher-education expenses. With both plans, any monies not used for qualifying expenses are subject to income taxes and a 10% penalty on earnings.

Saving for college is important and choosing the right plan for you is even more important. To learn more about Section 529 qualified College Savings Plans, consult a Certified Public Accountant.

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