Saving for College: Section 529 Plans

Recognizing the economic and social benefits of promoting education, federal and state lawmakers have developed a number of investment plans, government programs, and tax incentives to make higher education financially accessible to more Americans.

Probably the most recognized savings vehicle for funding college educations today is the 529 Savings Plan. Named after the section of the federal tax code that allows them, they offer significant tax benefits. There are three basic types of 529 plans: the State-Sponsored 529 Savings Plan, the State-Sponsored 529 Prepaid Tuition Plan, and the Independent 529 Plan.

State-Sponsored 529 Savings Plan

With a 529 Savings Plan, earnings accumulate tax-deferred and withdrawals can be made, tax-free, when it’s time to pay for a child’s college expenses including tuition, fees, room and board, and books. Investment minimums are low, as little as $25 per month, and there is no restriction on how much you can contribute every year unless the account is nearing the lifetime cap. For 2009 each individual is allowed to gift $13,000 per year to any individual gift-tax free. A special caveat to this applies to funding 529 plans: You may contribute as much as $65,000 in one year ($130,000 with your spouse) without incurring gift taxes, provided you do not make any further gifts for the following five years. Each state determines its own lifetime contribution limits, ranging from $100,000 to over $300,000. Contributions can only be made in cash; transfer of securities into plans is prohibited

Each program sponsored by a state offers an array of stock and bond funds for a participant to invest in. There is also an ‘age-based’ portfolio option given to investors. An aged-based portfolio will automatically adjust its allocation towards a more conservative position as your child grows older. Therefore, by the time your child is of college age, the portfolio will be almost exclusively in fixed income and cash positions. Under IRS rules, you may reallocate investments within a plan once a year. A special provision was created for the 2009 calendar year which allows an account owner to reallocate up to two times during the year. Unless extended, the original provision of one reallocation per year will return in 2010. Further, you can move from one state plan to another state plan with no tax consequences. As in the case of changing allocations, you can only move between state plans once a year. You will also want to pay attention to any fees you may incur by moving between state plans.

Many states do provide added benefits on their own in-state plans by providing state income tax deductions on contributions and exemption from state income tax for qualified plan distributions. Additionally, certain plans are provided asset protection from lawsuits and creditors. For example all 529 accounts, including out-of-state 529 accounts, having a Texas resident as owner or beneficiary is provided creditor protection by the Texas government.

What if your child does not go to college or doesn’t require the use of the funds set up for their benefit? You can get a full refund, but you’ll pay taxes plus a 10% penalty on your investment earnings. These penalties are waived if your child becomes disabled or dies. Further, if your child receives a scholarship, most plans will waive the penalties on withdrawals up to the scholarship amount.

An alternative to withdrawing the money is to change the plan’s beneficiary to another child or family member. A change of beneficiary must be to a first cousin or closer to the original beneficiary; otherwise, there may be adverse tax consequences. Each state has its own definition of ‘family member’ so be sure to contact your plan’s administrator if any clarification is needed.

Suggested State-Sponsored 529 Savings Plans

The general selection criteria for a savings plan program is usually centered on (1) fees and expenses, (2) investment options, and (3) other incentives that may be offered to in-state residents. A few suggestions when reviewing plans are: avoid high annual expense ratios and loaded funds, review the quality of the fund selection by each asset class, review extra benefits like state income tax deductions and asset creditor protection.

The quality of each 529 plan, rules and regulations, may vary dramatically by each program sponsor and by state plan. Some of these limitations can include age contributions limits, required distribution for beneficiaries over a specified age, minimum contributions amounts, and additional fees for out of state residence. It is very important to review the program details to insure complete understanding of the plan agreement before applying.

Other factors such as risk tolerance, time frame and family financial situation may affect what college savings vehicle or method is optimal for you. A prepaid tuition plan may offer features that provide greater advantages for your particular circumstances than a savings plan. Please contact MTR Financial Services for additional information and considerations.

Our suggested 529 Savings Plan list was selected based upon plan expenses and investment options for Texas residents. More information on these plans can be found at www.savingforcollege.com.

Review established 529 plans periodically to evaluate investment performance, plan agreement changes, and to monitor your specific college-funding objective.

Suggested State-Sponsored 529 Savings Plans

Related Articles:

• Independent 529 College Saving Plans
• State-Sponsored 529 Prepaid Tuition Plans
• College Savings Programs for Military Families
• College Planning Resources