What is a 529 Plan?
A 529 Plan is an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. It is named after Section 529 of the Internal Revenue Code which created these types of savings plans in 1996.
529 Plans can be used to cover the costs of qualified higher education institutions nationwide. In most plans, your choice of school is not affected by the state your 529 savings plan is from. You can be a California resident, invest in a Vermont plan and send your student to college in North Carolina.
Nearly every state now has at least one 529 plan available. It’s up to each state to decide whether it will offer a 529 plan (possibly more than one) and what it will look like, meaning 529 plans can differ from state to state. You should research the features and benefits of your plan before you invest, research state 529 plans, compare between plans, and make sure that the 529 plan fits into your overall financial plan.
As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant. Although contributions are not federally tax deductible, earnings in a 529 plan grow federally tax-free and will not be taxed when the money is taken out to pay for college or even graduate school. Contrast this with many other savings vehicles, such as mutual funds, that will give up a portion of their earnings to annual income taxes and also get hit with a capital gains tax at withdrawal, and the tax treatment of 529 plans is beneficial. This tax treatment was made permanent with the Pension Protection Act of 2006.
Your own state may offer tax breaks as well. In addition to the federal tax savings, 34 states, including the District of Columbia, currently offer residents a full or partial tax deduction or credit for 529 plan contributions. The state of Georgia provides for a $2,000 tax deduction on contributions. You can generally claim state tax benefits each time you contribute to your plan, so it’s a smart idea to continue keep making deposits until you’ve paid your last tuition bill. Be sure to research all of your options. If your state doesn’t offer benefits for residents, you can choose any other state’s plan.
Contributions to a 529 plan are considered a completed gift and therefore, any contributions that you make are removed from your estate for estate tax and generation skipping transfer tax purposes. Furthermore, instead of being restricted to the annual gift tax exclusion amount, you can claim up to 5 years’ worth of annual gift tax exclusions per donee in one year, which allows you to remove a large chunk from your otherwise taxable estate in a single year by making a large contribution.
You, the donor, stay in control of the account. With few exceptions, the named beneficiary has no legal rights to the funds so you can be sure the money will be used for its intended purpose. This differs from custodial accounts under UGMA/UTMA, where the child takes control of the assets once he or she reaches legal age. A 529 account owner can withdraw funds at any time for any reason — but keep in mind that the earnings portion of non-qualified withdrawals will incur income tax and an additional 10% penalty tax if not used for higher education expenses.
The accounts are fairly low maintenance. A 529 plan is a very hands-off way to save for college – to enroll, simply visit the plan’s website or contact your financial advisor. Most plans allow you to “set it and forget it” with automatic investments that link to your bank account or payroll deduction plans and become more conservative as the beneficiary closes in on college age. The ongoing investment management of the account is handled by an outside investment company hired as the program manager or by the state treasurer’s office.
The tax reporting is fairly simple. Contributions to a 529 plan do not have to be reported on your federal tax return. You won’t receive a Form 1099 to report taxable or nontaxable earnings until the year that you make withdrawals.
There is a lot of flexibility once the account is established. You can change your 529 plan investment options twice per calendar year. You can rollover your funds into another 529 plan one time in a 12-month period. You can also change the beneficiary to another family member, which may be useful if a child gets a scholarship and another child, grandchild, niece, or nephew has additional higher education expenses.
Everyone is eligible to take advantage of a 529 plan. Unlike Roth IRAs and Coverdell Education Savings Accounts, 529 plans have no income limits, age limits or annual contribution limits other than the lifetime contribution limits. There are lifetime contribution limits, which vary by plan, ranging from $235,000 – $400,000.
Can I do it myself?
An important question to ask is whether you will invest in a 529 plan directly, or will you use a financial adviser? Your answer to this question will help narrow down your choices, as about half of all 529 plans are sold through brokers.
Here are the two most common reasons for buying a 529 plan directly — a do-it-yourself approach to 529 investing:
- You will incur lower expenses with direct-sold 529 plans. Broker-sold 529s generally have higher annual costs and may include sales charges of anywhere from 1 percent to 5.75 percent of your contributions. Also, many of the direct-sold 529s (but few of the broker-sold) invest in index funds with low expense ratios.
- Your state may offer a direct-sold 529 plan with special incentives. If you are a resident, you may be eligible for a state income-tax deduction, a matching contribution, a scholarship or other financial-aid boost, or special protection of your account from creditors. While these benefits will not make your investment decision a slam-dunk, they should be factored into your decision. Research the specific features of your state’s 529 plan to see if any of these apply to you.
The biggest “cost” to the do-it-yourself approach is the time and effort you will have to invest to research the alternatives and get comfortable with the tax rules and other investment goals that apply to your personal situation.
Broker-sold 529s offer definite advantages as well. The most important benefit is that you will be receiving advice from a financial professional that can extend beyond planning for college. A capable professional will attempt to match the right 529 plan to your particular investment goals and risk preferences and help to coordinate your college planning with your other financial objectives, such as affording a comfortable retirement or minimizing potential estate taxes.
Comprehensive financial planning is no small task. And while many financial professionals are not permitted to dispense legal or tax advice, their knowledge of the quirky rules and restrictions surrounding the income tax and gift tax treatment of 529 plans can help immensely. Also, certain mutual funds are available only through broker 529s.
Even if you feel capable of doing the research and planning on your own, you may decide that the time you save by using professional financial help is worth the cost which typically will be either commission-based or fee-for-service. Brokers generally receive a commission on the amount you invest. Fee-only planners bill on an hourly basis or charge a certain percentage of the value of your portfolio.