A 529 plan, also known as a qualified tuition plan, is an education savings plan that is operated by either a state or an eligible educational institution. The purpose of 529 plans is to help families pay for future college costs. Every state now has at least one 529 plan. There are two types of 529 plans, savings plans and prepaid plans. Savings plans essentially operate like an investment account in that you contribute money to the plan with the idea that it will grow through investing so that there will be more money for the beneficiary when he or she goes to college. On the other hand, a prepaid plan allows you to purchase tuition certificates that lock in today’s tuition rates for the beneficiary to use when he or she attends college. As a general rule, savings plans are better when the beneficiary is young so the investment will have time to grow, while prepaid plans are better when the beneficiary is close to college age, because you can lock in lower tuition rates, and you have a better idea of where the beneficiary will attend college.
529 plans provide numerous benefits. First, the person setting up the account is able to provide for the beneficiary’s higher education expenses, which could occur a long time in the future. Second, the investment in the account grows while not being taxed, making it tax-deferred. Also, the distributions come out federally tax-free as long as the distributions are to pay for the beneficiary’s qualified higher education expenses. Third, under most plans qualified education expenses cover tuition, fees, cost of books, supplies, equipment, expenses for special services for a special-needs beneficiary, and reasonable room and board (cost of attendance under federal financial aid programs). Therefore, a 529 plan can pay for nearly all the costs the beneficiary will have while attending college. Fourth, the donor retains control of the account, which means that the donor decides when withdrawals are taken and for what purpose, whether or not to change beneficiaries, and most plans allow the donor to reclaim the funds. Although the donor retains control over the account, the contributions to the account still qualify for the annual exclusion for gifts and the funds in the account are not brought back into the donor’s gross estate. 529 plans also provide another benefit with the annual exclusion in that the donor can use five years worth of annual exclusion gifts in one year without paying gift tax. Thus, one donor could contribute $65,000 ($13,000 x 5) and a married couple could gift-split and contribute $130,000 ($26,000 x 5) without gift tax consequences in one year, which in some instances could fully fund the beneficiary’s higher education expenses. Lastly, 529 plans are very flexible. The account owner is able to change investment options once a year and can also rollover the plan into another state’s plan as long as it has not occurred in the last twelve months. Also, a 529 plan in one state can be used for education expenses in another state, and if the beneficiary ends up not going to college or needing all the funds, then the account owner can roll the funds over to another beneficiary.
As you can see 529 plans provide many benefits, but they also have some risks. First, with the savings plans investment risk is involved. The investment could lose value and potentially not provide as much money as you wanted for the higher education expenses of the beneficiary. Second, there is always the risk that the beneficiary will not go to college. This does not mean you will not be able to get the money out of the account, but withdrawals not used for qualified higher educations expenses receive a 10% penalty tax on top of being subject to income tax, and most plans cap the earnings at a low amount under such a situation. Some states also recapture any state tax deductions or credits used previously when the withdrawals are unqualified. Third, the investment options are limited by the state or educational institution administering the program, and therefore not all investment vehicles are available to invest in. Lastly, the investment option can only be changed once per year so you cannot change the investment strategy frequently as the market moves.
Private College 529 Plan
The Private College 529 Plan (PC Plan) is quite different from most plans, which is why I will discuss it specifically. This plan is a prepaid plan, and as the name suggests, this plan applies to participating private colleges, which is currently at 270-plus private colleges. The strength of this plan is the low-level of investment risk. The contributions are used to lock in tuition rates, and thus are not subject to the risk of the market as in savings plans. Prepaid plans have been especially beneficial in the recent economy because savings plans move with the stock markets, which have struggled in the recent economy, while prepaid plans continue to provide benefits as the colleges continue to increase tuition rates. Another strength of the PC Plan is that there are no fees involved. Since the contributions are used to buy tuition certificates rather than invested in a fund, there are no management-type fees involved.
The PC Plan also comes with some weaknesses. First, a tuition certificate cannot be redeemed until a minimum of 36 months has elapsed since its purchase and must be used within 30 years of its purchase. The consequence of these time restrictions is that you cannot fund the PC Plan right before the beneficiary enters college and expect to use the tuition certificates right away. Also, if the beneficiary does not end up going to college until later in life, the tuition certificates cannot be used if 30 years have passed. Second, the PC Plan involves not only the risk that the beneficiary will not go to college, which is a risk of all 529 plans, but also the risk that the child either will not want to go to one of the private colleges or will not be admitted. None of these 529 plans provide the beneficiary with an advantage when applying to colleges. If the beneficiary does not end up attending one of the private colleges participating in this plan, the money is refunded, but with only a 2% annualized return. Lastly, the PC Plan can only be used for tuition and mandatory fees. The PC Plan does not provide the benefit that other 529 plans offer of being able to use the funds for room and board.
529 plans can provide many benefits to all parties involved, but one must do his or her homework to mitigate the risks and assure that the proper plan is chosen. Many factors must be considered when choosing a 529 plan, such as the age of the beneficiary, where the beneficiary might go to college, the state tax deductions offered, the fees associated with the different investment options, how the investment options have performed, whether there are disincentives to switching plans, who can contribute to the plan, and what expenses can the funds from the plan be used for. After pinpointing the important factors, a donor can use savingforcollege.com to compare 529 plans and find the best 529 plan for his or her needs.