529 Tuition Plans 101: An overview of this tax-saving way to fund college

The cost of tuition has become so high that it is a serious obstacle for most college graduates to manage their student loan debt. Starting out in debt can actually limit a person’s financial success for the rest of their life, and that is the opposite outcome students hope for by going to college. If you want to ensure that a child or grandchild has the funds necessary to make their dream of a college education come true, a 529 qualified tuition plan may be a good choice for you.

These tax-advantaged savings plans, which are sponsored by states, state agencies, and educational institutions across the USA, derive their name from the fact that they are authorized under Section 529 of the IRS tax code. They fall into two categories; a prepaid tuition plan and a plan that lets you save for college. Every state in the county plus the District of Columbia offers at least one 529 plan and numerous universities also sponsor prepaid tuition plans.

Earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, and room and board. Contributions to a 529 plan, however, are not deductible. You can set one up and name anyone as a beneficiary. They could be a relative, a friend or even yourself. There are no income restrictions on either you, as the contributor, or the beneficiary. There is also no limit to the number of plans you can set up.

Check out the chart below to see some of the primary differences between these two types of plans.

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Prepaid Tuition Plan

College Savings Plan

Locks in tuition prices at participating colleges and universities. No guarantee of tuition costs.
Only covers tuition and mandatory fees, although some plans permit you to purchase a room and board option or use excess tuition credits for other types of related expenses. Covers a range of higher education expenses, including tuition, room and board, textbooks, and mandatory fees.
Most plans limit the age of the beneficiary (the prospective student). There are no age limits so even an adult can be listed as the beneficiary.
Many state plans are guaranteed or backed by state. No state guarantee. Your investment may not grow or could lose value, based on investment market fluctuations.
Typically have a limited enrollment period. Year-round enrollment.
Most state plans require either owner or beneficiary of plan to be a state resident. No residency requirement, however, nonresidents may only be able to purchase some plans through financial advisers or brokers.

How 529 Plans Work

The way the prepaid tuition plans typically work is that the university lets you buy units or credits that can later be applied to your future tuition. You may have to be a legal resident of the state where the college or university is located in order to be eligible for this kind of plan.

College savings plans, on the other hand, usually allow you to open a 529 savings account, name someone as the beneficiary, and select what kind of investment vehicle you want to use. Those include stock or bond mutual funds or even money market funds. You can also select a convenient age-based portfolio. Doing that automatically invests your 529 contributions according to how old the beneficiary happens to be.

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If the child is very young, for instance, an age-based strategy would invest for more aggressive growth of assets. If they are closer to college age the investments would be more conservative in order to avoid risk and ensure that the tuition funds are preserved and available to pay for college.

There are no tax consequences if you change the designated beneficiary to another member of the family. Funds distributed from a 529 plan are not taxable either, as long as they are rolled over to another plan for the benefit of the same beneficiary or for the benefit of a member of the beneficiary’s family. You could roll funds from the 529 plan for one of your children, for instance, into their sibling’s plan without having to pay a penalty.

Fees & Penalties

Normally, with rare exceptions, you can only withdraw money from a 529 plan for tuition – otherwise you will likely incur taxes and penalties. There may also be gift tax consequences. That could happen if your contributions to a beneficiary, plus any other gifts, exceed $14,000 in a single year. There may be other costs, too, such as brokerage commissions or mutual fund fees associated with your 529 plan, so be sure to factor all of those potential expenses before signing up for a plan.

Setting up a 529 plan is an investment decision, so you should definitely do your research and, if possible, consult a qualified tax planner or financial advisor to study all your tuition-saving options that offer tax advantages.

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