Section 529 plans, also known as Qualified Tuition Programs (QTP), are among the best ways of saving for your children’s college education. There are two types of section 529 plans, prepaid tuition plans and college savings plans. Both are named after section 529 of the Internal Revenue Code, which specifies the requirements for the plans to be free from federal income taxes. Prepaid tuition plans let you lock in future tuition rates at in-state public colleges at current prices and are usually guaranteed by the state. College savings plans are more flexible, but do not offer a guarantee.
Every state (including Washington, DC) now offers a state section 529 plan. Also, a group of several hundred private colleges offers a national prepaid tuition plan for private and independent colleges known as the Independent 529 Plan.
What is a 529 Prepaid Tuition Plan?
Prepaid tuition plans are college savings plans that are guaranteed to increase in value at the same rate as college tuition. For example, if a family purchases shares worth half a year’s tuition at a state college, these shares will always be worth half a year’s tuition — even 10 years later, when tuition rates may have doubled.
The main benefit of these plans is that they allow a student’s parents to lock in tuition at current rates, offering peace of mind. The plans’ simplicity is also attractive and most offer a better rate of return on an investment than bank savings accounts and certificates of deposit. The plans also involve no risk to principal, and often are guaranteed by the full faith and credit of the state.
Currently, prepaid tuition plans are operated by state governments, with the tuition guarantee based on an enrollment-weighted average of in-state public college tuition rates. A few have separate plans for two and four year colleges and for room and board. If the student attends an in-state public college, the plan pays the tuition and required fees. If the student decides to attend a private or out-of-state college, the plans typically pay the average of in-state public college tuition. The family will be responsible for the difference, if any.
Starting in 2004, individual educational institutions may offer their own prepaid tuition plans. The Independent 529 Plan is such a plan offered by a group of private colleges.
Most plans require that either the account owner or the beneficiary be a state resident when the account is opened. However, anybody can contribute to a prepaid tuition plan, including grandparents and friends of the family. This lets people give the gift of education. Section 529 plans are especially good for grandparents, because of the estate planning features.
Prepaid tuition plans are exempt from federal income tax, and are often exempt from state and local income taxes. Favorable state tax status may be limited to the state’s own plan. Some states offer a full or partial tax deduction for contributions to the state’s plan. See the Tax Status section for more details.
If the child dies or decides to not go to college, the plans can be transferred to another member of the family. The money in the plan is controlled by the account owner, not the child.
If the family moves out of state but the child attends a participating school, the family can still use the plan but may be held responsible for the difference between out-of-state and in-state tuition, depending on the plan. Some plans will treat such a student as an in-state student, allowing the plan to cover 100% of the cost.
A key potential benefit of prepaid tuition plans is they tend to act as a hedge against economic downturns. During recessions and for a year or two afterward, state governments tend to reduce support for higher education. This translates directly into increases in public college tuition rates. So when other investments are dropping due to a declining stock market, prepaid tuition plans will tend to increase. Thus a good diversification strategy would be to include a prepaid tuition plan with your other college saving investments, if only prepaid tuition plans didn’t have such a harmful impact on need-based financial aid.
There are two main types of plans:
- Prepaid Unit. Prepaid unit plans sell units that represent a fixed percentage of tuition, with 1 unit typically corresponding to 1% of a year’s tuition. Everybody pays the same price for the units and the price of a unit increases each year. The parent can buy as many units as they want each year.
- Contracts. Contract plans sell contracts, where the parent agrees to purchase a specified number of years of tuition. The purchase price depends on the age of the child and on the type of payment (lump sum or installment). Contract plans usually offer lower prices for younger children, since the state has more time to invest the money.
Prepaid tuition plans encourage parents to save for their children’s education and offer them peace of mind. They are not necessarily the best way to save for college, but provide a safe, affordable, tax exempt and convenient option for families who may not be very knowledgeable about investing. There are many benefits to prepaid tuition plans — especially for middle-income and upper-income families who may not qualify for need-based aid — but they are not for everyone.
Before investing in a prepaid tuition plan, parents should carefully evaluate the plan and their other investment options. From an investment perspective, a prepaid tuition plan is a low-risk, tax-advantaged investment vehicle, with earnings indexed to the average increase in tuition. Since tuition rates seem to increase at about twice the inflation rate, the earning potential is probably greater than the interest earned from bank savings accounts and certificates of deposit (CDs). On the other hand, the negative impact on eligibility for student financial aid eligibility should be taken into account.
If the parents are willing to accept a greater amount of risk, they might be able to do better investing on their own. Finaid’s prepaid tuition calculator compare the effective return on investment of a prepaid tuition plan with the after-tax return on investment of alternate investments. Some accountants advise families to invest in a diversified portfolio of mutual funds.
Details of the plans may vary significantly from state to state.
What is a 529 College Savings Plan?
Section 529 college savings plans are tax-exempt college savings vehicles with a low impact on need-based financial aid eligibility. Unlike prepaid tuition plans, there is no lock on tuition rates and no guarantee. Investments are subject to market conditions, and the savings may not be sufficient to cover all college costs. However, with this added risk comes the opportunity for potentially earning greater returns.
Most 529 college savings plans offer an adaptive asset allocation strategy based on the age of the child or the number of years until enrollment. These plans start off aggressively when the child is younger, and gradually switch to more conservative investments as college approaches. Typically they will use four or five age ranges, such as newborn-6, 7-9, 10-12, 13-15, and 16-18+.
The money in the plan is controlled by the account owner, not the child. So if the child decides to not go to college, they do not have access to the funds as they would with an UGMA account. Section 529 college savings plans are similar in many ways to retirement plans, such as 401(k) and IRAs, although with much higher contribution limits and more favorable tax status. Every parent should consider investing in a 529 college savings plan for their children.
Anyone can contribute money on behalf of a beneficiary. Relatives, friends, colleagues, acquaintances and even complete strangers can contribute to a child’s section 529 plan.
The favorable gift tax treatment of 529 plans makes them a good estate planning tool, especially for grandparents. See the Tax Status section for details. Federal law requires that a 529 college savings plan must have safeguards to prevent contributions in excess of those necessary to provide for the qualified higher education expenses of the beneficiary, but does not otherwise specify a limit on contributions. Each state therefore sets its own limit. Most states use a limit that is based on an estimate of the amount of money that will be required to provide seven years of post-secondary education (including both undergraduate and graduate school).
Section 529 prepaid tuition plans typically have a much lower contribution limit, based on the current cost of four years of in-state public colleges. Typically this ranges from $50,000 to $100,000. Most states allow for periodic transfers from your checking or savings account in addition to lump sum contributions. Automatic payroll deduction is less common, but is growing in popularity as the states add it.
Currently, investments in 529 plans are usually exempt from federal, state, and local taxes. Contributions to a section 529 plan may be deductible on your state income tax. Since state income tax benefits may be limited to the state’s own plan, look first at the plans in your state and/or the state in which the beneficiary lives.
If you cancel the account and receive a refund, you will have to pay federal income taxes on the earnings, plus possibly a 10% tax penalty. There is also a 10% tax penalty, except in cases of death or disability or receipt of a scholarship. There may also be state and local income taxes and penalties, in addition to any plan penalties.
Gift and Estate Tax Benefits
Section 529 plans also provide favorable federal estate and gift tax provisions, making them a valuable estate planning tool. There is an accelerated gift option that allows you to average gifts over $14,000 per beneficiary ($28,000 for married couples) over a five year period without incurring federal gift tax. So an individual can contribute up to $70,000 per beneficiary in one year and a couple up to $140,000 per beneficiary without incurring gift tax. If you give the full amount, you will not be able to give any gifts to the same individual during the five year period without incurring gift tax or using up a part of your lifetime exclusion.
Impact on Need-Based Financial Aid Eligibility
The need-based financial aid treatment of family assets depends on whether they are owned by the student or the parent. During need analysis, the federal financial aid formula assesses a percentage of student assets and a percentage of parents’ assets. Parent assets in retirement plans and the net market value of the family’s primary residence are also sheltered, as well as small businesses owned and controlled by the family. Accordingly, the impact of a college savings plan on need-based financial aid depends on whether the plan is considered a student asset, a parent asset, or neither.
A separate section discusses account ownership for each type of college savings vehicle and its impact on financial aid eligibility.
Qualified Higher Education Expenses
Qualified Higher Education Expenses for section 529 plans typically include tuition, fees, books, supplies and equipment required for enrollment or attendance at an eligible higher education institution.
Room and board are included only for students who are enrolled at least half-time. Room and board expenses are limited to the actual school charges for students who live on campus in housing owned or operated by the school, and to the school’s budget figures (as listed in the school’s published cost of allowance figures) for students who live off campus or at home and for independent students.
529 plans can also be used to fund graduate school. Some states, however, limit their plans to undergraduate education. Expenses for special needs services are also included if they are incurred by a special needs beneficiary in connection with enrollment or attendance.
Rollovers and Changes in Investment Strategy
Section 529(c)3(C) Change in Beneficiaries or Programs specifies the conditions upon which a rollover is permitted:
- Rollovers are permitted once per twelve month period to another section 529 program for the benefit of the same beneficiary.
- Rollovers are permitted for the benefit of another beneficiary who is a member of the family of the old beneficiary. There is no restriction on the number of times this can occur per twelve month period.
- Changes in the beneficiary are permitted if the new beneficiary is a member of the family of the old beneficiary. There is no restriction on the number of times this can occur per twelve month period.
Such rollovers are not considered a taxable distribution if they occur within 60 days of the distribution.
According to IRS Notice 2001-55, account owners may change the investment strategy selected for a section 529 account once per calendar year or upon a change in the designated beneficiary of the account.
For the purpose of changing the designated beneficiary, a “Member of the Family” includes the following:
- children and grandchildren of the old beneficiary and their descendants,
- the step-children of the old beneficiary (but not their descendants),
- the siblings and step-siblings of the old beneficiary (including brother, sister, stepbrother and stepsister),
- the parents and grandparents of the old beneficiary and their ancestors,
- the stepfather and stepmother of the old beneficiary (but not their parents),
- the nieces and nephews of the old beneficiary (son or daughter of a brother or sister, but not of stepbrother or stepsister),
- the aunts and uncles of the old beneficiary (brother or sister of the father or mother, but not of stepmother or stepfather),
- the in-laws of the old beneficiary (son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law and sister-in-law),
- the spouse of any individual listed above,
- the first cousins of the old beneficiary, and
- the spouse of the old beneficiary.
If the new beneficiary is not a family member, the change of beneficiary is treated as a taxable distribution to the account owner. The account owner will then owe income taxes and a 10% tax penalty on any earnings included in the transfer.If you change the beneficiary to a generation below the generation of the old beneficiary, there may be tax implications.
A database of all eligible schools can be found on the US Department of Education web site. You can also call the US Department of Education at 1-800-872-5987.