Definition
Also referred to as prepaid tuition and college savings plans, 529 plans are named after the section of the federal tax code that created these investments. The 529 is a tax-advantaged account that allows investors to save money for the higher education costs of the plan's beneficiary.
Explanation
Like Coverdell Education Savings Accounts, 529 plans provide tax benefits to individuals and families that are saving for college expenses. Originally, 529 plans were administered by state agencies and funding was aimed at public institutions of higher education. Today, 529 plans are administered and offered through private colleges and universities too.
There are two basic types of 529 plans:
Prepaid Tuition: allows the investor to purchase tuition credits at today's rates. With a prepaid plan, the plan's administrator assumes the risk the fund's growth will match the rising cost of tuition.
College Savings: investors contribute to the plan based on minimum and maximum installments, which are set by each plan. With a college savings plan, the investor assumes the risk the fund's growth will match the rising cost of tuition. Contributions to some plans can exceed $300,000 for a single beneficiary.
Money placed into the account can be used to pay for tuition, room and board, books, equipment, supplies and fees at an accredited vocational school, college or university. There are many different 529 plans offered, so it's important to understand the portability of the plan, fees, as well as their risks.
The contributions to a 529 plan are not tax deductible. The account grows on a tax-deferred basis and distributions to qualified beneficiaries are tax-free. The investor always remains in control of the account; however, non-qualified distributions are subject to income tax as well as a 10% tax penalty.
Plan beneficiaries encompass a long list of family members, including spouses; sons; daughters; adopted, step, and foster children; brothers and sisters; stepbrothers and stepsisters; brothers-in-law and sisters-in-law; fathers and mothers; aunts and uncles; as well as first cousins.
Under the federal gift tax laws, contributions to 529 plans are classified as gifts and excess contributions will count against the one-time gift exemption.
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