What the Fool Is a 529 Plan?

What is a 529 plan? A 529 plan, oh-so-colorfully named for section 529 of the Internal Revenue Code, lets you invest money to save for college expenses -- and enjoy a few tax breaks in the process.

Who offers 529 plans? All 50 states and the District of Columbia offer at least one kind of 529 savings plan. Some states require you to be a resident to contribute to their plans; others will welcome you and your money, even if you're from out of state. In addition, a group of colleges and universities offers what it calls the Independent 529 Plan.

What kind of 529 plans are available? 529s come in two main flavors:

• Prepaid tuition plans: Participants can purchase credits toward tuition at a state university. Given higher education costs' steady rise, this can be a good way to lock in tuition at today's prices, rather than shelling out more when Junior's finally ready to head off to college. This is less like investing in a mutual fund or brokerage account, and more like buying tuition on layaway.
• College savings plans: Participants invest money, managed either by the state treasurer or a private broker licensed by the state, in stock and bond mutual fund plans. These investments can help your savings grow faster, but their performance isn't guaranteed; you could end up losing money. Some states also offer FDIC-insured plans that grow at roughly the same rate as a savings account. Your money will be safer here, but you'll lose out on the chance for greater growth.

What kind of investments can I put in a 529? You can't pick individual stocks for a 529 college savings plan. In most cases, you'll choose from a limited menu of stock and bond mutual funds or fund portfolios. These plans tend to offer lower expense ratios -- the fees you'll pay each year for having your investments managed -- than most commercially available funds. Don't let that stop you from shopping around to see which states' plans offer the best mix of price and long-term performance. Some states also offer plans that will automatically adjust their allocations over time, shifting your investments from riskier, faster-growing stocks to steadier, safer bonds as Junior's college days grow closer.

If you're not happy with the investment you've picked within a 529 plan, you can shift all the money in your account from one set of holdings to another -- but you can only do so only once within a given year. However, you're always free to direct your next and future contributions to a different investment within the plan.

What tax advantages do 529 plans offer? Unlike a 401(k) or a traditional IRA, contributions to a 529 plan won't lower your federal taxable income. However, money invested in a 529 plan can grow tax-free, and the recipient won't have to pay any income tax on money withdrawn from the plan to pay for qualified higher education expenses -- tuition, fees, books and supplies, even room and board in some circumstances. In addition, some states will exempt any contributions you make from your state income tax (though, like we said, the federal government will still want its cut).

Do I need to have a child to start investing in a 529 plan? Nope. Anyone can start a 529 plan, and name anyone they like as the beneficiary. You can start a 529 plan for yourself, if you like, and start immediately withdrawing the money you invest (as long as it's going toward those qualified expenses we mentioned earlier).

You can also change the beneficiary of an account without taking a tax hit, as long as the new recipient is a relative -- a child, adopted child, stepchild, sibling or stepsibling, niece, nephew, or first cousin -- of the original recipient. (Parents, grandparents, aunts, and uncles can also become the new beneficiary, but they may have to pay taxes on the money.) So if you'd like to start saving for future hypothetical children, you can start a 529 plan in your own name, and switch beneficiaries later.

Note that while the money can only go toward the 529's beneficiary, it remains completely under the control of whoever started the account. In other words, your designated student can't raid the 529 without your knowledge to fund a spring break bash in Cabo. And more than one person can set up a 529 plans for the same beneficiary; if Grandma and Grandpa want to start their own 529 for your future scholar, they're free to do so.

What's the catch? If the money you take out of a 529 plan doesn't fund college expenses, you'll pay taxes and an extra 10% penalty on it. Note that this only applies to earnings on the money you've invested; you can take out the amount you've actually contributed at any time, without penalties.

In addition, what kind of college savings plan you choose could determine what kinds of fees you pay. Plans run by private brokerages, as opposed to state governments, may try to tack on additional expenses to their investments. Read the fine print carefully, Fools -- or better yet, just look for "direct-sold" plans, instead of "advisor-sold" plans.

There are limits on the total amount that anyone can contribute to a 529 account. They vary by plan, but most seem to hover around the $200,000 mark. The IRS also considers contributions to a 529 plan as gifts. For 2010, if you contribute more than $13,000 per person per year ($26,000 for couples filing jointly), or $60,000 in any given five-year period ($120,000 for couples), the IRS will impose taxes on the excess.

In some cases, 529 plans can diminish a student's eligibility for need-based financial aid. If your future scholar will depend heavily on this assistance, you'll want to check with your college of choice to see how big an effect a 529 might have.

Bear in mind that there are approximately eleventy bajillion different 529 plans. (Note: Not a scientific estimate.) Each may have its own rules, restrictions, and investment options, so don't assume that all plans are created equal.

Is a 529 plan worth the hassle? We think so. If you're going to save for college already, you might as well get a tax break while you're doing so. Whether you prefer the safety and stability of a prepaid tuition plan, or the flexibility of a college savings plan, 529s can be a great way to get the jump on higher education expenses.

Where can I learn more about 529 plans? Here at the Fool, we've got a whole bunch of archived stories about 529 plans to expand on this introduction. If you're feeling ready to shop around, the independent College Savings Plan Network will tell you all about the various states' plans, and let you compare and contrast them to see which works best for you.