529 Plans – Saving for College

Many parents and grandparents are using 529 Plans to fund their children’s and grandchildren’s education. However, 529 Plans are somewhat confusing because they are subject to Internal Revenue Code qualification requirements, but are operated by the various states or educational institutions under varying policies defined by them. 529 Plans established by the states come in two basic formats: (a) prepaid tuition plans and (b) savings plans. (Eligible educational institutions can only establish prepaid tuition plans; these institutions cannot set up savings plans.) Every state offers at least one 529 Plan.

A prepaid tuition plan is best thought of as a way to lock in the price of covered educational services at today’s prices, thus insuring against college cost inflation. The tax benefits are a nice bonus. In contrast, a savings plan is best thought of as a tax-advantaged way to build up a college fund. Savings plans do not lock in the cost of covered educational services. The federal tax advantages for both types of plans are identical. Each type of plan generally allows both one-time (lump sum) and periodic contributions. Since each state plan is unique, each one must be analyzed in terms of the student’s needs.

Many factors should be considered before opening a 529 Plan account. For many individuals, especially those whose children or grandchildren are years away from college, the savings plans generally will be the better choice. However, the volatility of the stock market, including years of negative returns, has renewed interest in prepaid tuition programs. Prepaid plans might be appropriate in certain circumstances, particularly for those with low risk tolerance or those who want to be guaranteed a certain amount of education credits or units. Whichever route is taken, it is important to review all of the program details, including investment options, fees, and state income tax consequences.

When a state income tax applies, individuals typically should look at their own state program first, as the state income tax consequences might make it more favorable than others. However, many individuals may find that out-of-state programs better meet their needs and objectives. Some families choose to open both a prepaid plan for the cost certainty and a savings plan for the growth potential.

Prepaid tuition plans allow individuals (generally parents) to prepay the education costs of a designated beneficiary (generally their child) at specified institutions and thereby lock in the price. The prepayments are invested by the 529 Plan. In effect, the investment return is guaranteed to keep pace with inflation in the cost of the covered educational services—nothing more; nothing less. Even if the plan’s conservative investments post inadequate returns, there is no obligation to make further payments. However, if the 529 Plan earns more than enough to finance the cost of the covered educational services, the plan gets to keep the excess. In either case, once college time arrives, the covered costs of the designated beneficiary will be paid for by the 529 Plan.

Unlike prepaid tuition plans, 529 savings plans make no promises that contributions will cover a given amount of future college education. As their name implies, savings plans simply provide tax-favored savings accounts for higher education expenses.

The bad news is that savings plans are not a surefire hedge against college cost inflation. The good news is that these plans allow upside potential. If the savings plan’s investment return exceeds the rate of inflation for college costs, less money is needed to fund the account. Basically, the account owner decides how much to contribute to the savings plan, chooses among the plan’s investment options, and then monitors performance. At college time, the account is drawn down to pay some or all of the designated beneficiary’s eligible expenses.

When determining the impact 529 Plans have on a student’s financial aid offer, it is important to recognize that how the 529 Plan is owned (titled) can impact the financial aid computations in two ways. First, it may be an asset that can be assessed in the financial aid computation. Second, withdrawals from the 529 Plan may be treated as a resource that has a direct impact on the student’s financial need (as an outside scholarship would).

Qualified distributions from state-sponsored 529 Plans and institutional programs are completely tax-free. Qualified distributions are distributions for qualified higher education expenses, including tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. A beneficiary with special needs can also include the expenses of special needs services as qualified expenses.

Finally, 529 Plans may be particularly attractive to higher income parents and grandparents because there are no AGI-based limitations on who can contribute to these plans. In addition, the federal income and estate tax aspects generally are favorable with 529 Plans.