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A few years back, Section 529 of the Internal Revenue Code authorized what are now referred to as 529 college savings plans or qualified tuition plans. 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 different types of 529 plans: those that are considered pre-paid tuition, and those that are true college savings plans. Presently, all fifty states offer at least one type of a 529 plan. You'll also find several colleges and universities that have teamed-up to offer pre-paid tuition plans.
To make sure this last point is clear; we're going to explain the difference between a prepaid tuition plan and a college savings plan.
Prepaid Tuition Plans
A pre-paid tuition plan offers 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 you a chance 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 account holder 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 those investments on behalf of the accountholder.
Typical investment options offered to accountholders as part of these college savings plans include:
College savings plans offer investors more flexibility than pre-paid tuition plans since these plans allow for withdrawals that can be used at any college or university. However, these plans are riskier than prepay 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
| 529 Features |
Prepaid Tuition Plans |
College Savings Plans |
| Ability to Lock in College Costs |
Yes |
No |
| Expenses Covered |
Tuition and mandatory fees |
Tuition, room & board, fees, books and computers |
| Contribution Limits |
Based on age of beneficiary and lump sum payments |
For some plans in excess of $200,000 |
| State Guarantees Possible |
Yes |
No |
| Residency Restrictions |
Yes, owner or beneficiary |
No |
| Age Limits |
Age and/or grade limits |
None |
| Enrollment Periods |
Limited enrollment periods |
No restrictions |
Tax Implications of 529 Plans
One of the nice features of 529 plans is they can offer individuals saving for college an added tax benefit. That's because all earnings or growth of a plan are not subject to federal, and sometimes state, income tax as long as the money is used to pay for eligible college expenses.
If the money is withdrawn from a 529 plan, and it is not used to pay for college expenses, you will likely have to pay income tax on the withdrawal. An additional 10% federal tax penalty may also apply to withdrawals. You'll want to also keep in mind that the tax benefits of all 529 plans are set to expire on December 31, 2010 if not extended by congress.
State Income Taxes
In addition to providing a federal tax shelter, some of the 529 plans sponsored by states also allow residents to claim a state tax deduction for contributions. They may also offer low income families matching contributions in the form of grants or additional benefits.
Since the state income tax implication of plans will vary from state to state, it's important to read through all of the plan materials before opening an account.
529 Fees and Expenses
This publication is only going to cover the basics of fees and expenses. The 529 plan rules can be quite complex, and require a topic of their very own. See our "additional resources" box for more information. That being said, it's important to understand the fees and the expenses that are typically associated with 529 plans.
As is the case with any investment account that is managed by third parties, 529 plans carry some very extensive fees that will eat into the overall return on your investment. For example, with a prepaid tuition plan you might be expected to pay administrative fees, enrollment fees, and a load. This fee structure is similar to those of mutual funds. These fees may be owed to the state itself, or they can go to brokers if they are involved.
Since most 529 college savings plans are sold and / or maintained by an investment house, brokers can charge additional fees such as an annual distribution fee. These fees can run between 0.25% and 1.00% of the account balance each year. Brokers will often reduce these types of fees as the college savings account balance grows. Once again, it's important to understand exactly how each 529 plan is structured, since 1.00% of $200,000 is over $2,000 per year.
About the Author - 529 College Savings Plans
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