If you've even vaguely paid attention to the college-savings scene -- or have seen any financial services commercials -- you've heard of 529 plans. And you've also probably thought, "That's as boring as calling a retirement account a 401(k)!"
Dreary government names aside, 529 college savings plans (named after a section in the tax code) have become all the rage with parents, and the financial services companies that want their money. Every state now has its own plan.
There are good reasons for this popularity. But any quick rise to fame is accompanied by complications (just ask MC Hammer). And despite their many shining qualities, 529 savings plans aren't right for everyone.
Is a 529 savings plan for you? Let's look at the pros and the cons.
Pro #1: Tax benefits galore
The earnings on the investments in a 529 savings plan will not be taxed by the federal government as long as they are used for qualified higher-education expenses (which include tuition, books, and room and board). If you participate in your own state's plan, you may be able to deduct the contributions on your state income tax return.
Not only will this cut your tax bill, but it makes more money available to grow through the years. This could potentially boost your college savings by thousands of dollars.
Pro #2: Financial aid friendliness
Any savings will reduce your eligibility for financial aid. But don't let that discourage you from saving, because of two big reasons: (1) There's no guarantee you'll get aid, and (2) most aid comes in the form of loans, so for most people the choice is save now or borrow later.
However, you can control how much your savings affect financial aid by choosing the right accounts. Generally, money in the student's name will have a bigger impact on financial aid than money in the parent's name, since colleges expect students to contribute a larger portion of their assets to the tuition bill. And this is where 529 savings plans shine.
The assets in a 529 are considered the property of the person(s) who opened the account, which are usually the parents but might be grandparents or other benefactors. Thus, savings in a 529 plan don't reduce financial aid eligibility as much as savings in a custodial account such as an UGMA, since those assets are considered to be the property of the student. (Note: A previous version of this article also stated that assets in a Coverdell Education Savings Account are considered property of the student. However, the U.S. Department of Education recently changed the financial aid treatment of such assets. For more information, read the announcement.)
Note that exactly how a 529 plan is treated varies from school to school. And since these plans are relatively new phenomena, colleges are just now grappling with how to treat these assets. So stay on top of developments.
Pro #3: Higher contribution limits
The most popular alternative to a 529 plan is the Coverdell ESA. While assets in a Coverdell also grow tax-free (and can also be used to pay for qualified elementary and secondary school expenses), there's a $2,000 annual contribution limit.
The contribution limits on 529 plans, however, are monstrously higher. Each state sets the limit for its plan, but we're talking $100,000 to $2000,000 over the lifetime of the account in most cases. So if you plan to set aside more than $2,000 a year, or want to invest a large lump sum, a 529 is the way to go. (Keep in mind that you can contribute to a Coverdell and a 529 for the benefit of the same child in the same year, so it's not an either/or situation.)
Con #1: Lack of investment flexibility
You've heard the upside, so now it's time for the downside. First, the law requires that 529 assets be professionally managed. In other words, you can't pick individual stocks, bonds, or other investments in a 529 account. You must choose from among the mutual fund-type investments offered within the plan. Further, you can only change your investment choices once every 12 months.
This is why it's very important to pick the right 529 savings plan. Start by examining your own state's plan because of the tax deduction mentioned earlier, as well as other benefits plans offer residents. But you don't have to choose your state's plan, or the plan in the state of the school you hope your kid will attend. You can live in Virginia, participate in Nebraska's plan, and use the money to pay for tuition at a school in California.
Con #2: Lack of uniformity and history
As noted earlier, these plans are new, and the rules (and quality) vary greatly from state to state. How can you judge the quality of the investment choices in a plan if it's been operating for just two years? How efficient is the plan in distributing money when you need it? How's the customer service? Do you have to keep money in the plan for a certain period of time before you make withdrawals? How do you report withdrawals on your tax returns? These are all questions that have plagued current and prospective 529 plan participants.
For help, visit savingforcollege.com for information on individual plans. And keep an eye on the big financial publications, such as Kiplinger's and Money, which regularly review 529s and pick the best plans.
Con #3: Will you really get those tax benefits?
The tax-free status of 529 distributions will remain only through 2010. After that, the accounts will be considered tax-deferred -- i.e., you won't get taxed on annual earnings, but the earnings portion of distributions will be taxable to the beneficiary. This is still a good deal, but not as nice as tax-free growth. Congress might make the tax-free treatment permanent before 2011, but it's no guarantee.
Also, some states are getting snippy about their taxes. New York, for example, might try to "recapture" deductions if residents move their assets from the state's 529 to another state's plan.
And whether distributions from a 529 plan will be free from state taxation is not easily answered. It depends on your state, and perhaps whether your assets are in another state's plan.
Is a 529 right for you?
As you can see, it's not an easy question to answer. If you're still undecided, visit our College Savings Center, which features a handy college savings plan comparison chart. Or if you'd rather curl up with a good book as opposed to a computer (which isn't conducive to curling), check out The Motley Fool's Guide to Paying for School: How to Cover Education Costs From K to Ph.D.
