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While we cover lots of material in our 13 Steps to Paying for College, one fairly recent development deserves your attention. 529 plans (named after the IRS code that sets forth the favorable tax treatment afforded these "qualified state tuition programs") are quickly gaining favor as the college savings vehicle of choice. Let's look at why.
What are 529 plans?
Generally, there are two types of 529 plans. Both are state-based, so the details and options differ from state to state (and some states are now doing hybrids of the two). Letting the states lay out the exact workings of the 529 plans has sparked competition among them to offer the best programs, because some states are now allowing non-residents to participate in their plans. These websites are good places to check out your particular state's offerings: www.collegesavings.org and www.savingforcollege.com.
The first type of 529 program is the prepaid tuition plan. It's basically a way for you and anyone else interested in your child's college education (e.g., a grandmother, adoring aunt, or family friend) to contribute money and lock in the current tuition rates for later. You can either buy tuition in years or units, and payment can be made as a lump sum or in monthly installments. Some states require you to sign a contract, committing a certain amount of money monthly to the plan. The program promises to pay out future college tuition at one of the state's public universities or colleges.
Should your child choose an out-of-state school, or a private one, you can still use the money accumulated to pay for his or her education. However, there is no guarantee that the money you've saved will cover it. Prepaid tuition plans are more hedges against tuition inflation (which, according to the College Board, is running around 4% a year for state schools and 5% for private schools) than true investment vehicles.
The second and increasingly more popular type of 529 program is the college savings plan. A college savings plan allows the parents, grandparents, and anyone else interested to save money for the child's college education in a special account. Some plans are run by state agencies, while others are run for the state by companies like Merrill Lynch and Fidelity. As you can probably guess, investing in these plans is very similar to investing in a mutual fund. But, we'll come back to this point in a bit.
What do these plans have in common?
Let's hit on some of the similarities in the two types of plans. Both plans are afforded the same tax treatment at the federal level -- that is, they are tax-deferred accounts until the child goes to college, and then the earnings are taxed at the beneficiary's tax rate. That rate can usually be counted on to be lower than the parents' unless you have a burgeoning 16-year old Internet entrepreneur. Most states will also treat the plans as exempt from state income taxes for residents, and some states allow residents to deduct contributions for state income tax purposes.
There are no income restrictions for contributions to these plans. Also, contributions usually have high maximums, making them much more attractive on both counts than an Education IRA, which has income restrictions and limits contributions for a single beneficiary to a paltry $500 a year.
529 plans also offer a twist on the conventional gift tax, which is triggered when gifts exceed $10,000 a year for a single recipient. It is possible for an individual to put $50,000 into a 529 plan in a single year and have it count as five gifts of $10,000 spread over the next five years, which makes the plan attractive for, say, grandparents who are whittling down their estates.
Also, and again unlike the Education IRA, you can elect to use the HOPE tax credit or the Lifetime Learning tax credit (provided you don't earn more than the income limitation) in the same years that money from a 529 plan is used. But, if you contribute to a 529 plan for your child, you may not contribute to an Education IRA for that child for that tax year.
The plans resolve the problems of control inherent in a Uniform Gift to Minors account. In those accounts, your child gets the money at your state's legal age (typically 18 or 21), and should she want to splurge for a spanking-new Porsche 911 rather than pay for college, there won't be much you can do about it. These accounts fix that because they are established in your name (or the name of whomever started the account for your child), and the money is not turned over to your child willy-nilly. As well, to receive the favorable tax treatment, the payouts must be for qualified educational expenses.
Although a 529 account may not technically be in the student's name, a ruling from the Department of Education sets out the treatment of 529 plans with regard to financial aid consideration. Prepaid tuition plans will be considered assets of the student, while college savings accounts will be considered assets of the account owner. What this means is that having a prepaid tuition account can negatively affect your child's ability to be considered for financial aid since the calculations to determine "need" will focus first on the assets of the student.
With both types of accounts, should your child decide to join the circus instead of going to college, you can transfer the money to another child in the family. If you choose to pull the money out instead, expect to pay a penalty and withdrawal fees as well as taxes (at your rate). Refund policies differ from state to state, with some states only refunding what you put in and none of your gains. (Ouch!)
How are they different?
Prepaid tuition plans only assure that tuition will be paid at one of the state's public universities, and the goal is to keep up with tuition inflation. If your child wants to go to a private college or an out-of-state school, you'll just have to deal with what the plan has earned you, and it probably won't be a market-matching return. However, there is more certainty with a prepaid tuition plan than with a college savings plan. Examining your child's time horizon is important. There is market risk with a college savings plan, though most plans tailor their investments according to the age of the child (i.e., more exposure to stocks the younger the child is).
One of the main things to realize about 529 plans is that you are giving up control of your money to a "professional." In both instances, you cede control to the people administering the plan, whether it's a state agency or one of the firms handling the state's 529 accounts. In a prepaid tuition plan, remember, the goal is to keep up with tuition inflation. With a college savings account, though, what matters most will be the investment strategy the firm or the state uses. It pays to do your homework and shop around for the best plan. Your state may not offer the best one. However, if you decide to go with an out-of-state plan, you won't get the in-state tax advantages.
What? Give my money to a "professional"?
The Fool isn't recommending that you hand your money over to professionals. We do, however, want you to be aware of all the options available to you for saving for your child's education. You'll have to weigh the pros and cons of 529 plans for your own situation.
To close, here are some other considerations to think about while deciding what is best for you and your family.
There are some great links at the bottom of this article that provide more information about your state's plan, and compare plans across states. Start today! Your child is depending on you.
What are you doing to save for your child's education? Take our poll and talk about it on the Specials discussion board.
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