Niche College Scholarship
Updated: August 8, 2016

An Introduction to 529 Plans

The Good, the Bad, and the Inconsequential

Whether your child is 15 months or 15 years old, now is the time develop a savings strategy for college. With tuition costs hiking, starting to save for college early on is something parents consider. The federal government authorized the creative of savings programs in an attempt to help millions of families afford to put their children through college. Tax-advantaged 529 savings plans are one of the most popular options, but surveys indicate that not many Americans are familiar with how to open, fund and receive tax benefits from the plans.

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Families should research plan details, compare their state plan to out-of-state-options and read up on plan investments.

An Overview of 529 Benefits

529 plans are named after section 529 of the Internal Revenue Code. They are designed to allow parents tax-free withdrawals for qualified educational expenses. The investment strategies, tax benefits, and incentives offered by 529 plans vary by state so research the advantages of both your state and others. Your own state may offer tax breaks, whether it be full or partial tax deduction or credit for 529 plan contributions. Funds from 529 plans can be used to meet costs at qualified colleges and universities nationwide.

Anyone can open a 529 account and there are no income limits for opening and funding an account. While the owner/account manager is in control of the account, family and families are allowed to contribute to the account. A 529 plan, unlike some other savings accounts, gives the account owner control and flexibility and allows for higher contribution limits. Funds can be withdrawn at any time for any reason but any non-qualified withdrawals will incur income tax and a 10% penalty tax. Contributions are not deductible but earnings in a 529 plan grow federal tax-free and won't be taxed when the funds are taken out to pay for college.

Some plans allow low monthly contributions so everyone can afford to put money away. Benefits include tax-deferred growth on deposits, protection from bankruptcy, and the ability to use funds at most colleges in U.S. and hundreds of institutions abroad.

The 529 plans are low maintenance and to enroll, you simply visit the plan's website or your financial advisor.

Types of 529 Plans

Savings Plans are college savings plans similar to IRA and 401(k) plans, insofar as they allow parents to save for a child's education tax-free through various investment options. Investment options can include stock mutual funds, bond mutual funds, and money market funds; as well as age-based portfolios that automatically shift toward more conservative investments as the student gets closer to college age.

529 Savings Plans fluctuate with the stock market, meaning it comes with the opportunity for potentially earning greater returns. The downside to this is that higher returns mean higher risks. Unlike prepaid tuition plans, savings plans do not lock on tuition rates, nor is there any guarantee.

Additionally, maximum contribution limits are high, minimum contribution requirements are low, there are no income limits/restrictions, and many states offer incentives for residents who contribute to their plans. As an added bonus, many accept contributions from other people, such as grandparents and family friends.

Prepaid Tuition Savings Plans are an option for families that are hesitant about investing money for college in the stock market. They allow parents to lock into tuition at the current rate and since they do not rely on the market, do not fluctuate in the event of an economic downturn. In fact, they may increase, unlike other investments that drop due to declining stock markets. These college savings plans are guaranteed to increase in value at the same rate as college tuition. Most plans require that either the beneficiary or account holder live in the state in which the account was opened.

The Independent 529 Plan, which is accepted by over 200 private colleges, also makes fixed contributions to portions of future tuition. Both of these varieties eliminates they worry about tuition inflation. However, if tuition holds steady or decreases between now and when the student starts college, a prepaid plan might not be the most lucrative option.

Like the 529 savings plan, anybody can contribute to the plan, including grandparents and family friends. If the beneficiary decides to not attend college, the funds can be transferred to another member of the family since the account is controlled by the account owner, not the child.

Costs Worth Considering

State-sponsored 529 plans are a great option for parents looking to invest money outside their stock. The federal government has outlined requirements of an approved plan, but the details affecting your pocket book vary by state. Review as multiple plans before determining which plan is best. In some states, residency determines eligibility and access to benefits. If you are considering an out-of-state plan, understand how fees and tax penalties affect your benefits. Look at all of your options before choosing the best plan.

A disadvantage to the 529 program is that funds can only be used for "qualified" higher education expenses. If your child does not go to college, the benefits are overrun by tax penalties. Unless you are 100% positive your kindergartener will be going to college, be cautious when looking into a 529 savings plan.

Beware of the following fees: Estimated underlying fund expenses, state fees, program manager fees, miscellaneous fees, annual distribution fees, total annual asset-based fees, and account maintenance fees. Fees vary by state, so before sure to do your research and weigh your options.