529 plan

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. The plans enable individuals tax-deferral of income and capital gains, and tax-free distributions for qualified education costs. 529 plans are termed "qualified tuition plans" by the IRS, which authorized the plans in 1996 in Section 529 of the Internal Revenue Code. The 529 plan provisions were made more secure by the 2006 Pension Preservation Act. 529 plans are sponsored by states and private education institutions. There are two types of 529 plans: pre-paid tuition plans, which can be offered by states or private institutions, and college savings plans which can only be sponsored by states. 529 savings plans can be sold directly to investors without sales charges, or can be sold through advisor sold plans with sales charges.

The law is quite liberal in allowing contributions to a child's 529 plan. Relatives, friends, and even complete strangers can make contributions (although all contributions are considered to be made by the account owner). The Federal government requires states to impose limits on contributions based on the expected cost of undergraduate and graduate educations. State contribution limitations on 529 savings plans range from $146,000 to $305,000. The median limit is $235,000. Limits on contributions to 529 prepaid plans range from $50,000 to $100,000. Unlike many personal retirement accounts and Coverdell Education Savings Accounts, there are no income restrictions placed on who can open and fund a 529 plan. The account owner maintains control of a 529 plan. This includes the power to name and change successor donors: to name and change beneficiaries; the ability to exchange one 529 plan for another; to allocate plan assets in 529 savings plans; and the power to disperse funds, or even terminate the plan. The benefit of maintaining control of the 529 plan is not the only advantage pertaining to the owner. The account owner's donations to the plan are deemed to belong to the beneficiary's estate and are thus removed from the donor's estate.

There are no limits as to the number of 529 plans that can be held for a beneficiary. For example, an investor could hold both a 529 prepaid or tuition indexed plan and a 529 savings plan for the same beneficiary.

529 Prepaid Plans
Prepaid tuition plans allow families to purchase the cost of future college tuition at present-day prices. The state offers a guarantee that the value of the investment will meet or exceed annual in-state public college tuition inflation. The price you will pay for such protection will vary, depending on the age of the student (lower for a young child; higher for older children) and, of course, the cost of tuition. There are two types of prepaid tuition plans, a units plan and a contract plan. A units plan allows you to buy units of tuition (for example, a unit could equal one percent of state college tuition). A contract plan lets you purchase contracts for one to five years of tuition. Account holders can usually contribute to either of the two plan types in a lump sum or in installments. . Investors can open a prepaid plan when the plans enter a limited open enrollment period, usually once a year. The prepaid plan will reveal its new tuition pricing with each new enrollment period. Prepaid plans can and do suspend enrollment periods. Timely information on a plan's enrollment period and current pricing are conveniently available on the Saving for College links in the second table below. Example:The Illinois 529 Prepaid Tuition Plan, a contract plan, will provide an example of prepaid tuition plan pricing for the 2008-2009 enrollment period. The plan allows payments in single installments; monthly payments over a five year term; and monthly payments over a ten year term. Plan beneficiaries are divided into three age groups: kindergarten and younger; first grade through eighth grade; and ninth grade and older. The contract pricing illustrated in the table below is for 9 semesters at a university and shows prices for attaining complete tuition payment. The plan also provides other schedules for payments for fewer semesters as well as for community college tuition.

In 2004 individual educational institutions were permitted to begin offering their own prepaid tuition plans. The Independent 529 Plan is a national prepaid tuition plan offered by a group of several hundred private colleges. The list below provides links to state provided 529 prepaid tuition plans, along with the Independent Plan.

The Colorado (units), Ohio (units), South Carolina (contract) and West Virginia (contract) plans have been closed to new investors for a number of years.

Prepaid plans can be costly if you decide to pull out the plan. Such action can result in stiff penalties, including a cancellation cost and/or loss of interest (see sidebar.) Prepaid plans also face the risk of funding shortfalls due to either portfolio losses or stresses  due to economic downturns (see Prepaid 529 woes: Bail out or sail on?).

529 College Savings Plans
529 savings plans are state-sponsored investment accounts. 529 portfolios are very similar to mutual funds and are managed by mutual fund companies. Assets inside a 529 savings plan can grow tax-deferred and are distributed tax free when used for "qualified education expenses". Unlike pre-paid tuition plans, the results one receives from a 529 savings plan are dependent on market performance and are not guaranteed. 529 savings plans offer greater flexibility of investment choices and can be used to pay for qualified expenses at any qualified institution. One is free to choose among any of the 529 savings plans issued by the 50 states and the District of Columbia.

For a side by side comparison of Prepaid and College Savings plans, please refer to this chart from FINRA.

529 Plan Investment Programs
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529 Savings Plans typically employ three main types of investment programs; age-based portfolios, static fund of funds portfolios, and standalone single asset class portfolios. Many states offer multiple 529 savings plans, often providing a direct-sold plan and an advisor (commissioned) sold plan. Many states provide both actively managed and indexed portfolios.


 * Age-Based Portfolios: Age-based portfolios are designed primarily for children beneficiaries. They are broadly diversified fund of funds portfolios that set allocations based upon a child's present age. The fund automatically changes allocations to more conservative postures as the child matures. The portfolios' glide paths normally run from birth to age 17 or 18, the time of expected matriculation. The figure to the right (click image to enlarge) shows the  asset allocation and glide path of one of the Ohio 529 plan's age-based portfolios. The portfolio is largely allocated to equities at early ages, with the equity allocation declining over time, until the portfolio is largely allocated to cash and bonds at age 18. A common feature of many 529 savings plans are multiple risk-based Age-based options, usually including a Conservative, Moderate, and Aggressive portfolio option. The North Carolina age-based plan of Vanguard  Life Strategy portfolios (figure on the left, click to enlarge) is an example of this type of offering. Asset allocations, glide paths, and returns can vary considerably among the eighty-odd 529 plan age-based portfolios.


 * Static Fund of Fund Portfolios: Another common offering in 529 savings plans is the static asset allocation fund of funds portfolio. These multiple fund portfolios maintain a constant asset allocation. These portfolios vary considerably. Some portfolios consist of stock funds, some are balanced across asset classes (stocks, international stocks, and fixed income). Some are exclusively invested in bond and money market funds. These funds allow an investor to choose an asset allocation and select the individual or multiple portfolios which match the desired allocation. The DFA portfolios in the West Virginia 529 Plan (SMART 529) provide a good example, with a wide selection of these type funds.


 * Standalone Portfolios: Some plans offer standalone asset class portfolios (see Virginia 529 Plan for an example), These type funds allow an investor to design and execute a specific asset allocation plan with individual asset class funds. With both static fund of fund portfolios and standalone portfolios the investor must decide if, and when, the allocation needs to become more conservative as the time nears for dispersing plan assets.

Tuition Indexed Programs
Two states, Arizona and Montana, offer 529 savings plans which utilize the College Savings Bank's tuition-indexed CD as the funding mechanism of the plan. The Collegesure CD is designed to provide a variable interest return that tracks the College Board’s Independent College 500 (IC 500) Index of four year private college tuition costs. The CD is offered with maturities ranging from 3 to 22 years and is backed by FDIC insurance. The Collegesure CD interest rate adjusts each July 31 when the IC 500 Index is updated. The annual percentage yield (APY) over the term of each CollegeSure CD is not less than the college inflation rate less a 3.00% margin. The CD carries a guaranteed minimium 2.00% interest rate

When you invest in the CD you purchase units. One unit, at maturity, is equal to one full year's average tuition, fees, room and board at the average four-year private college as measured by the IC 500 Index. Thus, if the current annual tuition cost as measured by the index is $37,200, a full unit would represent this value. Because of the 3.00% interest rate margin, the purchase price per unit exceeds the value of the IC 500 at the deposit date. In this example, today's cost for 10% of one year of private college ($3,720) would require a deposit of $5,736 to purchase .10 units of a CollegeSure CD for a three-year old child looking to enter college in fifteen years. At maturity you'll receive 10% of one year of whatever private college costs are in fifteen years (see graph at right.) Interestingly, since the interest rate is based on an index of tuition costs, an individual university may require less than or more than one unit of tuition. Based upon 2005 data, .44 units prepays about one year at the average public college (in-state). About 1.28 units prepays one year at the average Ivy League college

Consistent with most CD's, the Collegesure CD imposes penalties for early withdrawal.

Links to the Arizona and Montana 529 wiki page, and the CollegeSure CD product disclosure:
 * Collegesure 529 Tuition Indexed Programs
 * CollegeSure CD Product Disclosure

529 Plans Investment Considerations
Saving to meet expected college education expenses is one means of paying for college costs. Other means of meeting this financial obligation include parents' paying college costs out of cash flow, student's paying tuition from job earnings, and getting assistance from financial aid (grants, scholarships, and student loans). It is often advised that parents fully fund their retirement savings before beginning a college savings program. Should you elect to fund a 529 savings plan, the following considerations should help you make prudent decisions. [Note: the important topic of making changes to 529 plans: rollovers, beneficiary changes, and account owners changes, are considered in 529 Plan Account Transfers‎.]

Investment Strategy: The investment of college savings in a 529 Savings Plan should follow the fundamental principles embedded in the Bogleheads Investment Philosophy: emphasis on low investment costs; broad diversification both within and among asset classes; the use of low cost index funds when available; and careful consideration of risk. Emphasizing low costs suggests that 529 savings plan investors should eschew the advisor sold 529 plans and select among plans that are directly sold. In her study, Savings Incentives and Prices: A Study of the 529 College Savings Plan Market" (March 16, 2009), Vicki Bogan provides the following cost data on 529 plan expense ratios. The advisor sold plans also include sales charges, which are not included in the expense ratio.

The wiki page, 529 Plans Indexed Options, provides information on indexing options within the 529 savings plan universe. More detailed information on specific plans can be found on the wiki's individual state 529 savings plan pages.

In State or Out of State Plan: The selection of a 529 savings plan would optimally depend on the costs and investment selections offered by the plan. However, many states offer tax incentives  to residents for investing in an in state plan. These incentives can include tax deductions for contributions, state matching payments for contributions, or a combination of the two incentives. These tax incentives can make a marginally more expensive in state 529 plan competitive with lower cost out of state plans. The following guidelines can help streamline the plan selection process.


 * 1) If your state of residence does not offer any tax incentives, simply confine your selection from among the lowest cost providers, either in state, or out of state, with  investment selections acceptable to you.
 * 2) Five states (Arizona, Kansas, Maine, Missouri, and Pennsylvania) provide for tax deductible contributions to both in state and out of state 529 plans. You are free to select the lowest cost plan, either in state or out of state, with  investment selections acceptable to you.
 * 3) If your state provides tax incentives for 529 plan contributions, you can use the following factors to determine the breakeven point where using a lower cost plan option becomes cheaper than a state plan providing tax deductible and/or matched 529 contributions:


 * The tax savings amount (Deductible contribution x marginal state tax rate) + match.
 * The cost differential between the plan and the lower cost plan.
 * Dividing (1) by (2) provides the capital accumulation point where the lower cost plan subsequently overtakes the tax benefit. You can find your state's marginal tax rates from Tax Data available from The Tax Foundation.

Example: Herb and Susan Loughery, residents of Syracuse New York, are investigating their options for starting a 529 savings plan for their young son, David. Their in state plan, the New York 529 Plan, provides investment portfolios managed by Vanguard at a 0.49% expense ratio. Herb and Susan note that they can invest in similar investment portfolios managed by Vanguard in the Ohio 529 Plan at a 0.31% expense ratio. The state of New York allows Herb and Susan, as a married couple, to deduct $10,000 ($5,000 per person) per year of 529 contributions if they are contributed to the in state New York 529 plan. Herb and Susan have a state marginal tax rate of 6.85%. In this instance they find that their planned $10,000 annual investment into the 529 plan will mean that they can accumulate $380,555 in the New York plan before it would become more expensive than the Ohio plan (should the Loughery's either stop or lower their contribution level the threshold amount would, of course, drop.) In light of the generous tax incentive, Herb and Susan decide to opt for the in state 529 plan.

A number of states now recapture deducted 529 contribution taxes if a plan is transferred to an out of state plan. Refer to this table for a list of these states.

Miscellaneous:


 * Account owners may change the investment strategy selected for a section 529 account once per calendar year or upon a change in the designated beneficiary of the account.
 * Your contributions to a 529 savings plan may be invested into your portfolio selections much slower (up to a week lag) than the quicker transactional speeds that are common to private market investment programs (mutual funds, IRAs). Check with your individual 529 plan document for details on transactions.
 * Distributions from a 529 plan can be coordinated with distributions from Coverdell accounts, savings bond exclusions, and the American Opportunity and Lifetime Learning tax credits.

Federal Tax Benefits
Contributions to a 529 plan are not tax deductible on the federal tax return. However, earnings and capital appreciation are tax deferred in a 529 plan, and distributions are tax free for "qualified education expenses". According to the IRS "qualified expenses" are the amounts paid for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. They also include the reasonable costs of room and board for a designated beneficiary who is at least a half-time student. The cost of room and board qualifies only to the extent that it is not more than the greater of the following two amounts.


 * The allowance for room and board, as determined by the eligible educational institution, that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period and living arrangement of the student.
 * The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.

Federal Tax Penalties
Withdrawals from a 529 Savings Plan are considered non-qualified withdrawals if they are in excess of qualified education expenses. Non qualified withdrawals are taxed at the account owner's tax rate and subject to a 10% additional tax on the amount included in income. This 10% additional tax does not apply to distributions meeting the following exceptions:


 * Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
 * Made because the designated beneficiary is disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do any substantial gainful activity because of his or her physical or mental condition. A physician must determine that his or her condition can be expected to result in death or to be of long-continued and indefinite duration.
 * Included in income because the designated beneficiary received:
 * A tax-free scholarship or fellowship,
 * Veterans' educational assistance,
 * Employer-provided educational assistance or
 * Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
 * Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point).
 * Included in income only because the qualified education expenses were taken into account in determining the Hope or lifetime learning credit.

Exception (3) applies only to the extent the distribution is not more than the scholarship, allowance, or payment. The additional tax is figured on Part II of Form 5329.

Losses on 529 Plan Investments
If you have a loss on your investment in a 529 account, you may be able to take the loss on your income tax return. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that 529 account. You claim the loss as a miscellaneous itemized deduction on Schedule A (Form 1040), line 23 (Schedule A (Form 1040NR), line 11), subject to the 2%-of-adjusted- gross-income limit.

If you have distributions from more than one 529 account during a year, you must combine the information (amount of distribution, basis, etc.) from all such accounts in order to determine your taxable earnings for the year. By doing this, the loss from one 529 account reduces the distributed earnings (if any) from any other 529 accounts.

State Tax Benefits
States follow the federal tax system in allowing tax deferral of earnings and gains in a 529 Plan. Every state, with the exception of Alabama, allows tax free withdrawals from 529 plans for qualified education expenses. In addition, many states allow one to deduct or partially deduct 529 plan contributions on the state income tax return. Some states also offer a state match for plan contributions. This State Tax Deductions for 529 Contributions table provides a listing of all state tax deductions for 529 plans. Information is also available in our individual state 529 Plan wiki pages (see navigation box below).

Some states impose a recapture tax on prior tax deductions when a 529 plan is rolled over to another plan.

Estate Benefits
529 Plans confer a potential estate tax benefit to donors. Contributions to a 529 Plan are removed from the donor's estate and are transferred to the estate of the beneficiary. All yearly contributions below the $13,000 per recipient gift tax provision are removed from a donor's estate, and a special tax provision allows donors to donate up to $65,000 to a 529 plan in a single year without incurring gift tax. The donation is, for gift tax purposes, spread over the ensuing five years. The donations (prorated) are only brought back into the donor's estate if the donor dies or terminates the account within the five year extended period. If married, you and your spouse can "split gifts" and give $26,000 per recipient, and $130,000 for spreading the gift over five years. If you select the five year program you must elect it by filing IRS Form 709 - the U.S. Gift (and Generation-Skipping Transfer) Tax return. You must also file this return for any year your gift to a beneficiary exceeds the annual gift tax exclusion limit. You must also file the 709 for any year in the five year spread period if you make any additional gift to the beneficiary.

529 Plans and Financial Aid
For financial aid purposes, both 529 Savings Plans and 529 Prepaid Tuition Plans are considered parental assets, if the student is a dependent, no matter who (parent or child) actually owns the account. Parental assets are subject to a maximum 5.64% valuation assessment in federal needs analysis; student assets are assessed at a flat 20% rate.

Helpful Sites

 * Saving for College
 * Morningstar - 529 Plans
 * College Savings Plan Network
 * College Board
 * FinAid Section 529 Plans
 * FINRA - Smart Saving for College
 * Information for Financial Aid Professionals (IFAP) Library

529 Savings Plan Major Investment Managers

 * College Savings Bank
 * Fidelity 529 Plans
 * TIAA-CREF 529 Plans
 * Vanguard College Savings Center