Summer is almost over, and many a parent is already preparing for the back-to-school rush. If college is in your children’s future, you may also be wondering about the best way to save for this ever-increasing expense. One option is the 529 plan.
What is a 529 plan?
A 529 plan is a tax-advantaged investment vehicle sponsored by a state or educational institution that is designed to help families put aside funds to pay for future college costs. It’s named after Section 529 of the Internal Revenue Code (IRC).
There are two different types of 529 plans—prepaid tuition plans and college savings plans—and each comes with its own advantages and drawbacks:
- Prepaid tuition plans
- Allow you to pre-pay all or part of the costs of a college education and are guaranteed to increase in value at the same rate as college tuition
- Typically must be used at public colleges in a particular state
- Require tuition credits to be used by the time the beneficiary reaches age 30
- College savings plans
- Have no guarantees; the account owner bears the risk of investment returns
- Can be used at any college accredited by the U.S. Department of Education, at home or abroad
- Have no time limit on withdrawals
Your financial advisor can help you assess which plan type is the best fit for your financial goals.
529 plan benefits
Many people consider 529 plans a good investment, largely due to their federal, state, gift, and estate tax advantages. Let’s take a closer look.
Tax benefits. The primary tax benefits involve the treatment of contributions, earnings, and distributions. Similar to an IRA, earnings on contributions to a 529 college savings plan are tax-deferred; however, unlike a traditional IRA, distributions from the 529 plan are federal tax-free, as long as the funds are applied toward payment of qualified higher education expenses, which typically include tuition, fees, books, and supplies, and may include room and board.
In addition, all but seven states offer a full or partial income tax deduction on contributions made to a 529 plan. Your financial advisor can help you determine the availability and extent of the allowable income tax deduction.
A 529 plan can also serve as an effective gift and estate tax planning tool. A contribution to a 529 plan is considered a gift to the plan beneficiary; therefore, the amount of the contribution is deducted from the donor’s estate. The contribution is also considered a gift of present interest, which qualifies for the annual gift tax exclusion ($13,000 in 2011). Another gift tax benefit unique to 529 plans allows a donor to “front-load” five annual exclusions into one initial gift to the 529 plan beneficiary, and elect to treat the contribution as if the gift had been made over five consecutive years. This sum is removed immediately—gift tax-free—from the donor’s gross estate.
Control. When you, the plan donor, contribute to a 529 plan, the assets remain in your control. The named beneficiary of the plan has no rights to the funds. When it is time to distribute the funds to pay for the beneficiary’s college expenses, you are the one who controls when distributions are made and for what purpose. You can even take funds out of the plan for your own personal use at any time; however, any earnings on the withdrawal will be subject to income tax, and you will incur a 10-percent penalty tax.
Low maintenance. A 529 plan provides an easy, hands-off method of saving for future college expenses. Once you and your financial advisor find the appropriate plan, the enrollment process is simple and straightforward. The plan assets are professionally managed by the investment company, and you don’t have to touch the plan until it’s time to start taking distributions.
College expenses can be a great burden, but a 529 plan can help you manage the load. With so many options to consider when it comes to investing in these plans, it’s important to consult your financial advisor to discuss your needs and learn how the right 529 plan can help you pursue your college savings goals.
The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that a college-funding goal will be met. By investing outside of your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Investors should consult a tax or legal professional regarding their individual situation.
You should carefully consider the investment objectives, risks, charges, and expenses of any 529 plan before investing. Ask your financial advisor for an offering statement containing this and other information on the plan. Please read it carefully before investing.