Section 529 college savings plans (529 plans for short) are special investment accounts designed to help you save for college costs. Named after the specific section of IRS regulations that authorizes the accounts, 529 plans have been attracting millions of dollars annually since they first became available during the 1990s.
How 529 plans work
There are several features of 529 plans that make them attractive to college savers, but none is more important than their status as tax-free investment accounts. Contributions to 529 plans aren't deductible on US tax returns, but any withdrawals you make to pay for qualified education expenses will be exempt from US taxation.
You open a 529 plan in the name of a beneficiary (the future student) and then make contributions that will be used to pay for his or her education. Because 529 plans are investment accounts, any money you contribute will be allocated to investments, such as mutual funds. While most 529 plans allow you to choose your portfolio's asset allocation, others may require you to allocate money to investments chosen by the plan's managers.
How can 529 plans help?
Setting aside college savings in a 529 plan may be the most effective way to accumulate the money you'll need to pay for college education. While your net earnings in a traditional investment account are reduced by taxes each year, the money you contribute to 529 plans is allowed to compound in full year after year without taxation. As a result, your account balance in a 529 plan could end up being significantly higher than the balance in a traditional account holding the exact same mix of investments.
Saving for college with a 529 plan can also help you maintain the discipline and motivation required to achieve important financial goals. For example, automatically contributing the same amount to a 529 plan each month lets you buy more investment shares when prices are low and fewer when prices rise. Over time, your long-term average cost per share may actually be lower than the fund's long-term average price per share.
Qualified education expenses
The IRS defines qualified education expenses as "the amounts paid for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution." An eligible education institution is defined as "any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the Department of Education," including "virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions."
The IRS points out that this may include schools outside of the United States that participate in the US Department of Education's Federal Student Aid (FSA) programs. If you have questions about whether an educational institution is eligible for withdrawals from a 529 plan, school administrators should be able to tell you.
Choosing a 529 Plan
There are dozens of 529 plans now available to college savers, but they're not all the same. Some US states allow residents to deduct contributions to in-state 529 plans from state income taxes, which is a tax break worth exploring. Kansas, Maine and Pennsylvania allow contributions to any 529 plan to be deducted from state income taxes. If you're eligible for a state tax break, start shopping with in-state plans.
Next, pay attention to contribution limits. Some 529 plans have them, some don't, and it's better to work without a limit in case an unexpected windfall or an increase in income allows you to contribute more. Compare management fees as well. You want the lowest fees you can get in a 529 plan, as these fees eat away at your potential investment returns over time.
Each 529 plan offers a unique mix of investment options, and some let you choose your own investments. As a rule of thumb, the longer your investment time frame is, the more appropriate it may be to invest aggressively in stock investments. As your timeframe shortens and your investment priority shifts from growth to preservation of funds, it may be appropriate to allocate a greater share of 529 plan assets in more conservative fixed-income investments, such as bonds or money market funds. If you're uneasy with stock investments, look for a 529 plan that invests solely in bonds and money markets.
Finally, find out if the plan allows you to change beneficiaries. This preserves your earnings by letting you transfer the 529 plan to another child in case the original beneficiary decides against going to college. Withdrawals from a 529 plan that aren't used for qualified education expenses will be taxed at the current rate, and most plans levy a 10% penalty as well for early or unqualified withdrawals.
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