529 plan

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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.[1] The 529 plan provisions were made more secure by the 2006 Pension Preservation Act.[2] 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.[3]

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, once made, are under the control of the account owner). The Federal government requires states to impose limits on contributions based on the expected cost of undergraduate and graduate educations. State accumulation limitations on 529 savings plans range from $146,000 to $397,000 (typically aggregated per beneficiary across all plans with that state). The limits have risen steadily over the years with inflation. Additionally some 529 plans limit contributions (not just aggregated accumulations). 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.[4]

Contributions to a 529 are considered completed gifts, so any amount contributed is not part of the contributor's estate, but is part of the beneficiary's estate.

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.

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

"Benefits of Prepaid Savings Plans: from collegeboard.com.
  • Guaranteed. Accounts are guaranteed by state governments to at least match in-state college tuition increases.
  • Low-risk. Prepaid savings plans are considered a safe investment option for families that know where their children will go to college. They usually outperform typical savings accounts or CDs.[5]

Downsides of Prepaid Savings Plans:

  • Limited to state residents. Participation in the plans is often restricted to state residents or alumni of state colleges and universities.
  • Geared toward in-state public institutions. Your principal plus earnings may not cover tuition and fees if the student decides to attend a private or out-of-state college or university.
  • Conservative. For long-term college savers (with at least five years until their student attends college), there may be more productive investing options.
  • Refund/cancellation costs. Pulling out of a prepaid tuition plan can result in stiff penalties, including a cancellation cost and/or loss of interest.
  • Narrow definition of college expenses. For some plans, funds can only be applied to tuition and fees. Expenses such as room and board, course fees, and books, fall on the family to cover. Other plans allow funds to be used for such expenses if a family ends up with excess tuition units or if tuition and fees are reduced by scholarships.

Bear in mind that each 529 plan has its own set of rules and restrictions, which are subject to change. Make sure to request the most recent plan details from the plan administrators.[5]

Benefits of 529 saving plans:

  • Open to anyone. There are zero residency restrictions and no cap on income level
  • Easy to manage. Set up an account and your money is managed for you.
  • Low impact on financial aid. Savings are treated as a parental asset when aid is determined, which means that only 5.6 percent or less of the account's value is factored into calculating the Expected Family Contribution (EFC) for each academic year.
  • Can be used at most schools. Funds are good at most accredited public or private colleges or universities, community colleges, graduate schools, in the U.S. Some plans also recognize accredited vocational and international colleges.
  • The account holder controls the money. The parent or grandparent controls the money for the life of the account, even after the beneficiary turns 18.
  • Large contributions are possible. Some plans have contribution limits as high as $305,000 per beneficiary.
  • Gift tax exemptions. Contribute up to $12,000 annually without triggering any gift tax. You also have the option to make a lump sum contribution between $12,000 and $60,000, which is treated as if it was made over a five-year period.[6]

Downsides of 529 saving plans:

  • Risk. These plans are not guaranteed to make a profit—accounts can post losses in a tough stock market. Parents must be aware of the risks, and be prepared in case they come up short.
  • Short track record. Most programs have only been around a few years.
  • Limited choices. Account holders have a fairly limited range of investment choices, but new options (and new plans) are being introduced constantly.
  • Less disclosure. States are not required to share their performance with investors on a regular basis.
  • Account manager fees. These are higher than average, and can be as much as 1-2 percent of annual earnings.[6]I"
-- collegeboard.com

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.[5] 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,[7] 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.
Beneficiary's Age One time payment 5 year monthly 5 year annual 10 year monthly 10 year annual
Kindergarten and younger $64,675.00 $1,305.00 $15,002.00 $782.00 $8,928.00
First grade to Eighth grade $67,953.00 $1,371.00 $15,757.00 $821.00 $9,377.00
Ninth grade and older $70,126.00 n/a n/a n/a n/a

In 2004 individual educational institutions were permitted to begin offering their own prepaid tuition plans. The Private College 529 Plan[8] 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.

State 529 Prepaid Tuition Plan Plan Type Saving For College Link
Alabama Prepaid Affordable College Tuition (PACT) (closed) Contract Alabama
Florida Florida Prepaid College Plan Contract Florida
Illinois College Illinois! Contract Illinois
Kentucky Kentucky’s Affordable Prepaid Tuition (closed) Contract Kentucky
Maryland Maryland Prepaid College Trust Contract Maryland
Massachusetts U.Plan Prepaid Tuition Program Contract Massachussetts
Michigan Michigan Education Trust Contract Michigan
Mississippi Mississippi Prepaid Affordable College Tuition Program (MPACT) Contract Mississippi
Nevada Nevada Prepaid Tuition Plan Contract Nevada
Pennsylvania Pennsylvania 529 Guaranteed Savings Plan
Pennsylvania Prepaid 529 Plan
Units Pennsylvania
Tennessee Baccalaureate Education System Trust (BEST) Prepaid Tuition Plan Units Tennessee
Texas Texas Guaranteed Tuition Plan (closed)
Texas Tuition Promise Fund (open)
Units Texas
Virginia Virginia Prepaid Education Program (VPEP) Contract Virginia
Washington Guaranteed Education Trust (GET) Units Washington
no state Private College 529 Plan Units n/a

The Colorado (units), Ohio (units), South Carolina (contract) and West Virginia (contract) plans have been closed to new investors for a number of years. Starting November, 22, 2010, the Tennessee (units) plan will no longer sell new units in the plan.[9]

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.[10]

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

Ohio Age Based 529 Savings Plan
North Carolina Age-Based Plan

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.[11][12][13]
  • 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 SMART 529 Select plan 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

CollegeSure CD

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[14] 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.[15] 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.[16]

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.[16]

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:

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),[17] 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.

Mean 529 Plan Expense ratios[18]
529 Plan 2002 2003 2004 2005 2006
Direct Sold 0.975% 0.999% 1.029% 0.993% 0.858%
Broker Sold 2.000% 1.257% 1.199% 1.349% 1.685%

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:
  1. The tax savings amount (Deductible contribution x marginal state tax rate) + match.
  2. The cost differential between the plan and the lower cost plan.
  3. 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.

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:

Helpful Resources for Coordinating Educational Distributions:


  • Account owners may change the investment strategy selected for a section 529 account twice 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[19] and Lifetime Learning[20] tax credits.[21]

Tax considerations

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.[22] 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.

  1. 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.
  2. The actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.[23]

Federal tax penalties

Withdrawals from a 529 Savings Plan are considered non-qualified withdrawals if they are in excess of qualified education expenses. "Generally, if you receive a taxable distribution, you also must pay a 10% additional tax on the amount included in income."[24][25] This 10% additional tax does not apply to distributions meeting the following exceptions:

  1. Paid to a beneficiary (or to the estate of the designated beneficiary) on or after the death of the designated beneficiary.
  2. 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.
  3. Included in income because the designated beneficiary received:
    1. A tax-free scholarship or fellowship,
    2. Veterans' educational assistance,
    3. Employer-provided educational assistance or
    4. Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
  4. Made on account of the attendance of the designated beneficiary at a U.S. military academy (such as West Point).
  5. 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.[26]

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.[27]

State tax benefits

States follow the federal tax system in allowing tax deferral of earnings and gains in a 529 Plan. Every state allows tax free withdrawals from both in-state and out-of-state 529 plans for qualified education expenses, with the exception of Alabama, which only exempts Alabama 529 plan qualified withdrawals. 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. If the total of all gifts to a single recipient in a year are under the annual gift tax exclusion ($14,000 in 2014), no gift tax return is required. A special tax provision allows an individual to contribute up to $70,000 to a 529 plan in a single year without incurring a 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.[28] If you select the five year program you must elect it by filing the IRS Form 709 - the U.S. Gift (and Generation-Skipping Transfer) Tax return.[29] 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.[30] If married, you and your spouse can each make contributions and give $28,000 total per recipient and $140,000 if spreading the gifts over five years, both without incurring a gift tax.

Asset protection advantages

Both federal law and many state laws confer asset protection advantages to both owners and beneficiaries of 529 plans. At the federal level, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 shields from creditors 529 assets owned by a bankrupt beneficiary, provided the deposits meet certain criteria (for example, the deposits must have been made at least two years prior to bankruptcy). Many state laws provide protections as well, and unlike the federal legislation, the state-level protections apply to claims brought outside the bankruptcy process. Specifically, the following states provide creditor protection to both owners and beneficiaries of 529 plan assets: Alaska, Arkansas, Colorado, Florida, Kansas, Kentucky, Maine, North Dakota, Pennsylvania, South Dakota, Virginia, and West Virginia. Louisiana and Wisconsin have laws protecting beneficiaries of 529 plans but not owners.[31]

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.[32]

See also

References

  1. Section 529 of the Internal Revenue Code
  2. 2006 Pension Preservation Act
  3. An Introduction to 529 Plans, SEC.
  4. FinAid Section 529 Plans
  5. 5.0 5.1 5.2 529 Prepaid Plans, collegeboard.com
  6. 6.0 6.1 529 Savings Plans, collegeboard.com
  7. Illinois 529 Prepaid Tuition Plan
  8. Private College 529 Plan
  9. Treasury Department to Offer Financial Incentive for College Savings Accounts, Discontinue Sale of New Units in Prepaid Tuition Program (11/22/2010)
  10. See Prepaid 529 woes: Bail out or sail on?)
  11. The Best and Worst 529 College-Savings Plans, Morningstar
  12. Age-based investment options show wide variation
  13. Asset Allocations in Age-Based Portfolios - Direct
  14. College Board’s Independent College 500 (IC 500) Index
  15. FDIC insurance
  16. 16.0 16.1 Arizona 529 plan FAQ
  17. " Savings Incentives and Prices: A Study of the 529 College Savings Plan Market" (March 16, 2009)
  18. Bogan, Vicki, "Savings Incentives and Prices: A Study of the 529 College Savings Plan Market" (March 16, 2009).
  19. American Opportunity
  20. Lifetime Learning
  21. How 529 Plans Help Families Save for College and How the American Recovery and Reinvestment Act of 2009 Expanded 529 Plan Features
  22. eligible educational institution
  23. IRS Publication 570, Tax Benefits for Education
  24. IRS Publication 570, Tax Benefits for Education
  25. What is the penalty on an unused 529 plan?, savingforcollege.com
  26. IRS Publication 570, Tax Benefits for Education
  27. IRS Pub 970
  28. Saving for College, FinAid.com
  29. IRS Form 709 - the U.S. Gift (and Generation-Skipping Transfer) Tax return
  30. Section 529 Plans: Filing Tax Returns and Reporting Contributions, Margaret A. Munro.
  31. State Creditor Protections for 529 Plans, CFED Policy and Practice Working Paper.
  32. Section 529 Plans, FinAid

External links

Sources

Helpful sites

Major investment managers

Bibliography