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529 Plans: A Tax-Free Way to Save for College

By Fred Yager
ConsumerAffairs.com

February 28, 2007

• Illinois Settles Lawsuit Over College Savings Fund • College Tuition Costs Jump • Texas Senate Places Limits On Tuition Hikes • As College Tuition Skyrockets, So Does Presidents' Pay • Colleges, Not Students, Often Benefit From Financial Aid • Aging Parents Face College/Savings Squeeze • New York Lawmakers Toughen Student Loan Rules • Multi-State Agreements Reached in Student Loan Investigation • Colleges Agree to Clean Up Student Lending Practices • New York Sues Student Loan Lender • 529 Plans: A Tax-Free Way to Save for College • Why Does College Cost So Much? • Financial Aid Information --- • Complaints about Student Loans • More about Education

As ConsumerAffairs.com recently reported, the cost of sending your child to college has escalated faster than practically any other family expense.

These days, many families are forced to choose between money set aside for retirement or dipping into, or even depleting, those funds to pay for their children's education. It doesn't appear that college costs are going to come down any time soon. So what can you do to prepare for this ever-increasing financial burden?

One solution that appears to be gaining in popularity is the state-sponsored 529 college savings plan. This plan allows you to save money free of state and federal taxes and to use it tax-free, providing you use it for a qualified form of higher education, such as public or private colleges and universities. Clown school might not pertain.

If you wonder where the "529" came from, that's the number of the section in the Internal Revenue Code describing the tax advantages of state-sponsored college savings plans. While 48 states and the District of Columbia each have their own 529 plan, there are actually only two distinct types.

The first is a prepaid plan that lets you buy tuition credits at today's rates and then use those credits when your child goes to college. The idea here is to head off tuition inflation.

The second type is a savings plan that allows you to put money into an account and to have that money grow tax free over time.

Both work best when you start the plan early, such as when your child, or grandchild, is in pre-school, or even still in the crib.

Twenty seven states and the District of Columbia even allow residents to deduct part of what they contribute to their home state's plans on their state income tax returns. Pennsylvania, Kansas, and Maine offer up-front state tax deductions for 529 contributions.

How much these tax benefits help will depend on your tax bracket as well as what you invest in. If the investment option, such as a mutual fund you're putting money into isn't growing more than 5%, you may want to shift to a fund with a better return.

Muddy Waters

Created by Congress ten years ago, 529 plans were slow to attract attention at first, possibly because there was so much confusion over how much the plans cost in terms of fees and what they had to offer in investment options. To further muddy the waters, each state has its own plans and some plans are more attractive than others.

But the combination of skyrocketing education costs and Congress' recent action to make permanent the plans' tax-free element as long as the money is used for education is prompting more parents to consider them.

By the end of last year, assets in 529 savings plans reached nearly $91 billion. The consulting firm, Financial Research, says by 2011, those assets are expected to nearly triple to more than $257 billion.

Many plans are offering more investment options and have even lowered their fees by as much as 50%. This reduction is important because high management fees could erase any gains from the tax benefit. According to savingforcollege.com, low-cost plans tend to charge under 0.6% in annual fees on their cheapest options that invest in equities. Ohio has the lowest fee of 0.25%. New York's 529 Savings Plan charges 0.55%.

It may be surprising to learn that you don't have to live in the state that sponsors the plan you use. Since each state's plan is slightly different, with varied investment options and differing costs, it pays to shop around for the right plan.

However, to attract residents to their plan, some states offer extra incentives, so make sure you check those out as well.

Check out your own state's 529 plan first because 31 states and the District of Columbia offer benefits such as tax deductions to residents for investing in their plan. If you live in a different state, chances are your state won't offer a tax break if you invest in another state's plan.

Then compare the tax breaks to the investment costs. If your state plan offers a tax break without low-cost investment options, you may want to look at other plans. Other states still have high fees and poor investment options and some don't offer the same tax breaks. To do this comparison shopping, go to www.savingforcollege.com or www.collegesavings.org.

If you didn't start saving when your child was a toddler, that's OK. Parents of high school seniors can still take advantage of 529 plans. That's because they can deposit up to five years' worth of contributions, or $120,000, without getting hit with gift taxes provided they don't add any more money for the next five years.

Other Options

Keep in mind there are other college-savings options to think about. There's something called a "Coverdell Account" and custodial accounts for minor children created under the Unified Gift to Minors Act. Coverdell accounts have been around as long as 529 savings plans; custodial accounts have been around much longer.

An advantage for 529 savings plans is that they allow you to change the account beneficiary. If one child doesn't need it because they receive a scholarship or decide to make a career out of auditioning for "American Idol," you can use the account for another child.

Some states let you shift the funds into a retirement account and use it yourself; by contrast, money in custodial accounts technically belongs to the child, who could take control of it once he or she reaches legal age, which, depending on the state, is either 18 or 21.

Lately, grandparents have been putting money into 529 plans for their grandchildren. The benefit here is that by removing assets from their estates, it could mean less tax for their heirs to pay when the grandparent dies.

One last cautionary note: some brokers have been caught selling clients more expensive out-of-state 529 savings plan rather than an in-state plan with tax breaks as a way of boosting their commissions. The lesson here is to deal with someone you trust who will help you work through the maze of plans, each with different investment options, costs, and features.

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