The 411 On College Savings Is a 529 Plan

As you plan for your children's education, there are several ways for help parents to invest and save to cover tuition costs.

Some — like the Uniform Gift to Minors Act, UGMA, and the Uniform Transfer to Minors Act, UTMA, custodial accounts — are taxed at the child’s lower rate, but because they are irrevocable gifts they are also considered a “student asset” for the purposes of determining financial aid. As a result, they could bump your child out of eligibility for student loans.

Others, like the Coverdell Education Savings Account, ESA, allow parents to put money away and pay no federal capital gains tax on the earnings if the money is used for qualifying educational expenses.

But Coverdells, formerly known as Education IRAs, also come with a low annual contribution limit ($2,000) and an income cap. (Contributions start to phase out for single filers at $95,000 and for married taxpayers who file jointly at $190,000.)

Then, of course, there’s your friendly IRA. Money from your Roth or traditional individual retirement account can be used to cover higher education expenses without incurring a 10 percent early withdrawal penalty—though most financial planners advise against borrowing from your future unless you’ve got cash to spare.

Enter the 529.

Thanks to their now permanent tax-free status, these qualified tuition programs — named after a section of the tax code — have fast become the MVP for parents struggling to meet or beat the rising cost of higher education.

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“With the cost of college being what it is, to really save effectively, I think the 529 is going to be your primary vehicle, even if you do end up putting some additional money into a Coverdell or [UGMA/UTMA] taxable account,” says Joe Hurley, a certified public accountant and founder of savingsforcollege.com.

According to the nonprofit College Savings Plans Network, CSPN, more than 10 million 529 accounts have been opened, with nearly $135 billion invested as of June 30, 2010.

Despite their popularity, however, 529s remain a source of confusion for many parents -- and grandparents.

It’s no wonder. Since most states operate their own 529, each with its own set of investment options and fees, those looking to open an account face a staggering number of choices.

“It can be daunting and perhaps a little frustrating,” says Hurley. “You find quite a variety of investment options and many other differences between the plans that may or may not be important to you.”

How They Work

A little background and some research tools, however, can help you decide which plan – if any – best meets your needs.

For starters, there are two types of 529s: prepaid tuition plans and college savings plans.

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In either case, money held in the account can be used to pay for tuition, room and board, fees, books and supplies. There are no income limits on contributions and you can participate in virtually any plan across the country. Your child is not required to attend school in that state.

In most states, minimum contributions can be as little as $15, helping young families save slowly, according to the CSPN, and you can generally contribute as much as $300,000 (or more) per beneficiary.

Prepaid plans, which are less popular among savers, are currently available in 12 states, allowing parents to purchase units of future tuition at today’s rate, a big plus considering tuition costs continue to climb at roughly twice the annual rate of inflation.

According to the College Board, a nonprofit association of schools, colleges and universities, the value of the investment in a prepaid plan is guaranteed by the state to meet or exceed annual tuition inflation.

Though they involve minimal risk, prepaid tuition plans are designed specifically to cover the costs of tuition at an in-state public university. Your principal and earnings may not cover the cost of tuition and fees if your child decides to attend a private college or out-of-state school, notes the College Board.

College savings plans, on the other hand, are investment-based instruments.

Money placed in your account is invested (typically in mutual funds) based on your selections.

Most state-sponsored 529s offer age-based investment options in which the underlying investment becomes more conservative (bond-heavy) as the beneficiary approaches college-age. Some, too, offer stable value or a guaranteed option designed to protect an investor’s principal while providing for some investment growth, the CSPN reports.

The biggest benefit of the 529 savings plan is that the earnings grow tax-deferred and withdrawals are tax-exempt, as long as the money is used for qualified education expenses.

You’ll owe income tax on withdrawals made for non-educational expenses, plus a 10 percent federal tax penalty. Not to worry, though, if your child receives a scholarship, the earnings portion of the amount you withdraw (not the contributions) will be taxed at the beneficiary’s tax rate, but it will not be subject to the 10 percent penalty.

Another potential perk of the 529 is that if you select the plan sponsored by your home state, you may be eligible for additional tax benefits.

Now for the downside.

Because 529 savings plans are investment-based, they do involve risk. There is no guarantee that your account will keep up with inflation and it could lose value like a common stock or mutual fund.

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“You have to evaluate [529 savings plans] like you would any other investment,” says Cindy Bailey, executive director of education finance services for the College Board. “You can get into a fund that is a real dog or into a fund that is really great. You should apply the same research when you go looking at these plans as you would for any other plan.”

Don’t overlook fees and expenses, which vary dramatically and can lower your return. (According to Savingforcollege.com’s 529 fee study, the 529 savings plan offered by Louisiana is the least expensive, charging no annual account fees for its fixed income fund managed by the state treasurer, while the District of Columbia’s 529 savings plan costs nearly $2,500 over a 10-year period on a $10,000 investment.)

Savingforcollege.com provides a comparison of the lowest and highest 10-year expense totals for all direct-sold 529s on its website. You should also be aware that some state plans also offer limited investment options from which to choose.

Financial Aid

One of the biggest questions for many parents is how any 529 savings will affect their child’s eligibility for federal financial aid (most often in the form of student loans).

Fortunately, assets held in a 529 generally have a low impact on financial aid.

According to the College Board, savings are treated as a parental asset when aid is determined, which means that a maximum of 5.6 percent of the account’s value is factored into calculating the Expected Family Contribution, EFC, for each academic year.

“The worst scenario is to put money into your child’s name in a mutual fund or other type of taxable investment because that gets counted as their asset which is heavily assessed in the financial aid formula,” says Hurley. “529s and Coverdell ESAs are assessed very lightly regardless of whose name it is put in.”

That said, what’s not to like.

“It really encourages people to save, especially small savers who can’t imagine saving $30,000, but can imagine putting $15 away each week,” says Bailey. “It fits very nicely with a young family’s budget—and also are very good for grandparents.”