Subject: Education Savings Plans - Section 529 Plans

Last-Revised: 17 Sep 2003
Contributed-By: Chris Lott (contact me)

Tax law changes made in 2001 introduced a college savings plan commonly called a "529 plan" (named after their section in the Internal Revenue Code). These plans allow people to save for college expenses.

There are actually two types of 529 plans being offered by different states. One kind is a pre-paid tuition plan; the other is a more general savings vehicle. Participants in pre-paid plans are usually strongly encouraged to use their credits at certain state schools, and might not get full benefits if they choose an out-of-state school. Participants in 529 savings plans can use their funds for any accredited institution in any state.

Funds in the account, as in an IRA, grow free of taxes. Contribution limits are high; each state sets its own limits. Very few states impose any income limits (meaning that if you make too much money, you cannot contribute to one of these plans). Anyone can contribute: parents, grandparents, etc.

Different versions of 529 plans are offered in all 50 states, and there is no restriction on state residency to use a state's plan.

So for example, if you live in Maine, you could invest in Hawaii's 529 plan. However, the benefits may differ depending on the state where you live. So if you are the Maine resident who is considering the Hawaii plan, you should certainly ask about the Maine plan's benefits.

Many state plans offer significant benefits to state residents. A resident may pay a lower management fee than an out-of-state plan member. A state resident may be able to deduct 529 contributions from his or her state taxable income, which reduces the amount of state income tax due to their state. Note that companies marketing plans from other states may conveniently "gloss over" these benefits.

One feature of these plans that makes them most attractive to many people is the amount of control that the donor retains over the funds. Unlike gifts made under a Uniform Gifts to Minors Act or a Coverdell Education Savings Account, where the minor owns the funds, the intended beneficiary of a 529 plan has no right to the money. In fact, many states allow the donor to revoke the donation and get the money back (although subject to various taxes and penalties).

A common complaint about 529 plans is the lack of choice in the investments available for participants. State plans are usually managed by some large financial institution. That institution may choose to offer only load funds or other investments that charge fees higher than the fees on comparable investments available outside the 529 plans. Further, many plans restrict how often funds can be moved among the investment choices, usually only once a year.

Withdrawals that are used to pay qualified expenses, including tuition, fees, and certain other expenses are free of tax on any earnings. If the money is withdrawn for any other purpose, both state and federal income tax is due on any earnings, and further Uncle Sam demands a 10% penalty on those earnings. (Of course tax law can change at any time; the tax-free withdrawal provision is currently set to expire in 2010.)

These plans are suitable for many families but certainly not all. The implications for financial aid computations are not clear and vary with each educational institution. It's probably safe to say that if you have enough income that you will never qualify for financial aid, then a 529 plan is exactly right for you.

If you have determined that a 529 plan is right for you, your job is not done yet. Because there are so many plans out there, and so many sales pitches from brokers and other financial institutions, choosing one can be exceedingly difficult. Some items to research about these plans and alternatives include the contribution limits (how much can you stash away), the advantages you may attain, the range of investment choices, and (last but certainly not least) the fees demanded by the account custodian. You can draw parallels to the big debate over load versus non-load mutual funds without really trying.

According to publication 970, Tax Benefits for Higher Education (page 46), the IRS allows you to roll savings bonds into a 529 plan. The benefit is that there is no tax due on the savings-bond interest. You don't actually do a pure rollover; instead, you cash in the savings bonds and put the proceeds into a 529 plan. To dodge the taxes, you must meet certain income limitations and file IRS form 8815 that year. This form is used to exclude interest from Series EE and I-Bonds when used to pay qualified education expenses.

Here are a few web resources on 529 plans:

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