529 College Savings Plans
Section 529 of the Internal Revenue Code authorized what are now referred to as 529 college savings plans or qualified tuition plans, which were passed as part of the 2001 Economic Growth and Tax Relief Reconciliation Act. These plans are sponsored by individual states and educational institutions to encourage the growth of college savings accounts.
Prepaid Tuition or College Savings
Section 529 allows for two types of plans: those that are considered pre-paid tuition, and those that are true college savings accounts. Presently, all fifty states offer at least one type of 529 plan, while a number of colleges and universities have teamed-up to offer pre-paid tuition plans.
Prepaid Tuition Plans
A pre-paid tuition plan offers parent-investors the opportunity to save for college by purchasing a unit, usually in terms of college credits, at participating colleges or universities. Some plans also offer the opportunity to prepay for room and board. Generally, prepaid tuition plans are sponsored by states, and therefore have a residency requirement. As part of this arrangement, most states guarantee investments in plans they sponsor.
College Savings Plans
College savings plans allow the accountholder to establish a fund on behalf of a student for the purpose of paying future college expenses. With this type of plan, the accountholder usually has several investment options from which they can choose. The plan itself makes investments on behalf of the accountholder.
Typical investment options offered as part of these plans include:
College savings plans offer investors more flexibility than pre-paid tuition plans, since they allow for withdrawals that can be used at any college or university. However, these plans are riskier than prepaid plans because they are not guaranteed by state agencies.
The following table outlines the major differences between 529 prepaid tuition plans and college savings plans:
529 Plan Comparison Table
Tax Implications of 529 Plans
One of the nice features of 529 plans is they offer families an additional tax benefit. Earnings, or growth, of a plan are not subject to federal, and oftentimes state, income tax as long as the money is used to pay for eligible college expenses.
If the money withdrawn from a 529 plan is not used to pay for college expenses, then income taxes are due, and an additional 10% federal tax penalty may apply. The Pension Protection Act of 2006 made the federal income tax exclusion for qualified withdrawals from 529 plans permanent.
State Income Taxes
In addition to providing a federal tax shelter, some of the 529 plans sponsored by states allow residents to claim a state income tax deduction for contributions. They may also offer low income families matching contributions in the form of grants or additional aid.
Since the state income tax implications of plans will vary, it's important to read through all of the plan materials before opening an account.
529 Fees and Expenses
The 529 plan rules can be quite complex, and require a topic of their very own; see the above "additional resources" box for more information. It's also important to understand the fees and the expenses that are typically associated with 529 plans.
As is the case with any investment account managed by third parties, 529 plans carry some very extensive fees that will eat into the fund's overall return on investment. For example, with a prepaid tuition plan, the investor might be expected to pay administrative and enrollment fees as well as a load. This fee structure is similar to those of mutual funds and may be owed to the state itself, or go to brokers involved with the transaction.
Since most 529 college savings plans are sold and / or maintained by an investment house, brokers can charge annual distribution fees, which can run between 0.25% and 1.00% of the account balance each year. Brokers will often reduce these types of charges as the balance in the college savings account grows. Once again, it's important to understand exactly how the fees in each 529 plan are structured, since 1.00% of $200,000 is over $2,000 per year.
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