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529 Plans: What You Need to Know

A 529 College Savings Plan is a tax-advantaged investment vehicle that is designed to help parents save - consistently over time - for their child's college education. The name "529" is derived from the applicable provision of the Internal Revenue Code that authorized the tax-favored status of these savings plans.

The principal benefit of a 529 plan is that the earnings on the underlying investments accrue free from federal and state taxes, and upon distribution, no federal taxes are paid, as long as the funds withdrawn are used for eligible educational expenses. Many states also similarly exempt qualified withdrawals from state income taxes. Thus, parents can avail themselves of the significant compounding effect on earnings that accumulate tax-free over time.

Eligible educational expenses include tuition, fees, books, supplies and any equipment required for studies at any accredited institution of higher education in the United States.

The administration of 529 College Savings Plan is administered by each state. Although each state establishes its own plan, administration and record keeping is usually delegated to an appointed third-party, usually an investment management company whose mutual funds comprise the available investment options offered to plan participants.

529 plans are offered in two varieties: prepaid and savings. Prepaid plans allow the donor to purchase future tuition credits at today's rates. Since tuition costs have far exceeded the rate of inflation for many years, prepaid plans offer a way for parents to lock-in the current cost of college, to be applied in the future as an inflation hedge, when, if historical trends continue unchanged, tuition rates will be significantly higher.

Savings plans rely on the market appreciation of the underlying investments, which principally consist of mutual funds. Most savings plans rely on an investment strategy of age-based asset allocation among the various fund classes.

During the early years of the plan's existence, investments are more heavily weighted in stocks or other aggressive growth investment vehicles, as denoted by the state's plan administrator. As the beneficiary approaches college age, the asset mix is adjusted to more conservative, less risky investments, such as fixed-income bonds or conservative growth equity funds. Under some plans, the fund manager performs these asset-class adjustments automatically at the appropriate time.

Plan donors who anticipate applying for financial aid at the time of the beneficiary's enrollment should be aware of a significant distinction between prepaid and savings plans. 100% of prepaid plans are considered a parental asset for purposes of federal financial aid formulas, and as such, may reduce a family's eligibility to receive financial assistance.

Savings plans, by comparison, are also treated as a parental resource, but only 5.6% of the plans assets are considered available to offset college costs in each year of matriculation.

In order to induce broad participation in their 529 College Savings Plans, most states have endeavored to keep administrative costs and fees as low as possible. Additionally, most state plans have low monthly minimum contribution amount requirements, which can be effected through payroll deduction or automatic deposit from a savings account. Some states allow significant (up to $300,000.00)maximum contributions, as well as the ability to deduct all, or a specified portion, of the contributions on a donor's state income tax return.

Since many states allow non-residents to participate in their 529 plans, parents have an array of choices when establishing a College Savings Plan. For those individuals contemplating out-of-state 529 plans, an important caveat regarding in-state financial aid eligibility, as noted above, needs to be restated. Some states may factor in the full amount of a resident's out-of-state plan for purposes of awarding in-state financial aid. Check with your state's 529 administrative agency for details.

Since 529 College Savings Plan can vary significantly from state to state, before selecting a 529 plan, parents should examine their unique circumstances, including their state tax situation, the investment objectives of the mutual funds offered, and, whether any limitations of their particular state plan, including a lack of suitable investment options, may be too restrictive and inflexible in light of their peculiar needs.

Parents would be well advised to review each state's 529 plan specifications and benefits thoroughly, as offset by any income tax advantages for residents that would be secured by remaining in-state, and choose accordingly.