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529 Plan 101: The Basics of 529 Plans

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529 Plan 101: The Basics of 529 PlansPeople use a variety of different investment vehicles to save for their children’s education, including IRAs, custodial accounts, and 529 plans.  529 plans are by far the most popular option.  So what is a 529 plan and how does it work?

First Things First

Saving for a child or grandchild’s education can be very important.  However, it may be wise to make sure you have taken care of some of the basics first, such as the following:

How Does a 529 Plan Work?

Now back to 529 plans.  There are two types of 529 plans, the prepaid tuition plan and the savings plan.  With a prepaid tuition plan, you can pay future college expenses at today’s rates.  However, there are some drawbacks to using the prepaid tuition plan.  For most people, the 529 savings plan, or qualified tuition plan, is probably the safer, more flexible, and better bet, which is what I describe below.

A 529 savings plan is a state sponsored savings and investment program.  It is a tax advantaged savings vehicle specifically devised to help people save for future higher education expenses.  You simply sign up for a plan, make contributions, and choose an appropriate investment option.  Then sit back and (hopefully) watch your assets grow.  You also have the option to periodically change the investment option you choose within the account.

There are very few limitations on who can open a 529 plan account.  In general just about any adult US citizen or resident can open a 529 plan account for themselves, a spouse, a grandchild, a child, friend, or other relative.  There are no income or age limitations on who can open or contribute to an account.

Although many different people can make contributions to a 529 plan account, generally only the account owner may control the assets.  He or she may also be the only person eligible to claim any tax benefits.

Once a 529 plan account is opened, you can generally transfer the account to other members of the beneficiary’s family with no tax consequences.  In other words, if any of your children decide not to go to college or don’t need the money, then you can transfer the account to another one of your children.

Some people advocate an IRA over a 529 plan because you have additional flexibility if you decide not to use the funds for education.  This is true, but I personally prefer to separate my retirement savings from my education savings since retirement savings as a general rule should not be sacrificed to pay for education expenses.  Additionally, many types of IRAs have fairly low contribution limits.  If you use an IRA as an education savings vehicle, you may be limiting your ability to use it as a retirement savings vehicle.

Tax Considerations of 529 Plans

Income Tax Considerations

Although you receive no federal income tax deduction for contributions to a 529 plan, earnings grow federal income tax deferred and may be withdrawn federal income tax free if used for qualified higher education expenses, which includes expenses such as tuition and fees, books, supplies, and room and board for students enrolled at least half time.

Additionally, some states provide a state income tax deduction for 529 plan contributions, which may only apply to residents of those states.  I highly recommend that people first take a look at their own state’s plan(s) to see if there are any desirable state tax benefits that would not be available to them if an out of state 529 plan were chosen.  Fees may be higher for non-residents.

529 plan funds may generally be withdrawn by the account owner at any time he or she desires.  However, if the funds are not used for qualified higher education expenses, then the earnings will generally be subject to federal (and possibly state) income taxes and a 10% federal tax penalty.

Gift Tax Considerations

Funds contributed to a 529 plan are considered to be a completed gift to the beneficiary for US gift and estate tax purposes.  Generally, gifts of up to the annual exclusion amount may gifted tax free, without using up any of the donor’s applicable exclusion amount.  In 2012, individuals may give up to $13,000 ($26,000 if splitting the gifts or if the property gifted is community property) to each donee without exceeding the annual exclusion amount.

There is, however, a special tax provision that allows an individual to make an election to gift up to $65,000 in 2012 to a single 529 plan beneficiary in one year and treat the gift as a series of five equal annual gifts.  As long as no additional gifts are made by the donor to the same beneficiary during those five years, no taxable gifts will have been made.

If you find written Chinese easier to understand than this gift tax jargon, don’t worry.  Unless you are fairly wealthy, you probably won’t ever have to worry about the gift tax rules when making contributions to a 529 plan.

Estate Tax Considerations

Even though the 529 plan account owner controls the funds in the account, 529 plan assets are generally not included in the account owner’s gross estate.

Choosing a Plan

Each state has at least one 529 plan, and you can generally use any 529 plan in any state you wish, regardless of whether you are a resident of that state.

529 plan funds may be used at any university, college, or technical school that takes part in federal financial aid programs for students in the US or abroad.

There are a number of solid 529 plans out there.  There are also a few that aren’t so great.  Since 529 plans are constantly evolving (i.e. lowering fees, adding additional investment options, etc), it is hard to nail down one 529 Plan as being continuously the best option that I can recommend to you today.  The best option today may not be the absolute best option a year from now.

If you are looking into opening a 529 plan, I highly recommend that you first take a look at your own state’s plan(s) to see if there are any desirable state tax benefits that would not be available to you if an out of state 529 plan were chosen.  This benefit must then be weighed against any potential disadvantages of your state’s 529 plan(s) when compared to other plans, such as high fees, few investment options, etc.

I personally believe that many people are able to open and maintain a 529 plan account on their own without any problem.  However, if you would like assistance, a financial advisor will be able to help you.

My 529 Plans

Personally I have chosen to use the Utah 529 plans, and I’ll tell you my thought process behind it.  The state I am resident in does not offer any special tax breaks for using my own state’s plan.  I took a look at its plan and found it to be fairly mediocre, so I started looking elsewhere.

I found a number of great plans, many of which would have worked just fine for me.  It was a tough decision but I ended up choosing the Utah 529 plan because it has solid investment options, extremely low fees, and there is no minimum contribution required to open or maintain the account.

I also liked that it has a direct-sold option, meaning that you don’t have to go through an advisor or broker to open up an account and make contributions.    If I were a resident of Utah, I would be entitled to additional Utah tax breaks for contributing to the Utah 529 plan.

The Utah 529 plan allows many different contribution options, including recurring automated contributions, which is what I use.  I simply designate an amount I want to contribute to each account each month and the contribution is made automatically without me having to even think about it.

I think it only took me about 15 minutes to set up an account and link my checking account to it.  I would guess that accounts in other states are just as easy to set up.

Top 2012 529 Plans

Morningstar recently came out with its list of top 529 plans for 2012.  As I mentioned earlier, 529 plans are constantly changing, so these may not always be the top choices.  Here were the top 4 mentioned for 2012:

  • AK: T. Rowe Price College Savings Plan
  • MD: Maryland College Investment Plan
  • UT: Utah Educational Savings Plan
  • NV: The Vanguard 529 College Savings Plan

Final Thoughts on 529 Plans

  • If you haven’t already, consider creating a budget to see how much can afford to contribute to your 529 plan.
  • Make sure you are investing your education funds wisely.
  • There are a million other ways to prepare for education expenses in addition to just setting money aside.  For example, Upromise is a free program that allows you to earn additional cash back for college on certain purchases you are already making.
  • Even if you can’t contribute much, consider opening an account and contributing just $5 a month.  Every little bit will help.

Additional 529 Plan Information

For additional information about 529 plans, check out the below books:

What are your thoughts about 529 Plans?  If you already have an account, which one do you use and why?  What other education savings vehicles do you use?  Please leave a comment below! 

Image: MaryPerry/bigstock


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