The ABCs of 529 Plans
If you're already saving for college, you've probably heard about 529 plans. 529 plans are revolutionizing the way people save for college, similar to the way 401(k) plans revolutionized retirement savings. Americans are pouring billions of dollars into 529 plans and contributions are expected to increase dramatically in the coming decade.
Since they were created by Congress in 1996, 529 plans (officially known as qualified tuition programs) have emerged as one of the top ways to save for college.
What exactly is a 529 plan?
A 529 plan is a college savings vehicle that has federal tax advantages. There are two types of 529 plans: college savings plans and prepaid tuition plans. Though college savings plans and prepaid tuition plans share the same federal tax advantages, there are important differences between them.
College savings plans
College savings plans let you save money for college in an individual investment account. These plans are run by individual states, which typically designate an experienced financial institution to manage the plan. To open an account, you fill out an application, choose a beneficiary and start contributing money. However, you can't hand pick your own investments as you would with a Coverdell ESA, custodial account, or trust. Instead, you typically choose one or more portfolios offered by the plan, the underlying investments of which are exclusively chosen and managed by the plan's manager. After this, you simply decide when, and how much, to contribute.
If you begin a plan early on, financial managers typically invest money based only on the age of your beneficiary (this is known as an age-based portfolio). Under this model, most of the portfolio's assets are allocated to aggressive investments when a child is young. As a child ages, the portfolio's assets are gradually and automatically shifted to less volatile investments to preserve principal. The idea is to take advantage of the stock market's potential for high returns when a child is still many years away from college and lessen risk later on.
Today, more 529 plans offer a wide array of portfolio choices. In addition to choosing an age-based portfolio, you may also be able to direct your contributions to one or more "static portfolios," where the asset allocation in each portfolio remains the same over time. Static portfolios can range from aggressive to conservative, so you can match your risk tolerance. Keep in mind that college savings plans don't guarantee your return. If the portfolio doesn't perform as well as you expected, you may lose money.
When it's time for college, the beneficiary of your account can use the funds at any college that is accredited by the U.S. Department of Education.
Prepaid tuition plans
Prepaid tuition plans offer an alternative to college savings plans. These may be sponsored by states (on behalf of public colleges) or by private colleges.
This vehicle lets you prepay tuition expenses now for use in the future. The plan's money manager pools your contributions with those from other investors into one general fund which are then invested to meet the plan's future obligations (some plans may guarantee you a minimum rate of return). At a minimum, the plan seeks to earn an annual return at least equal to the annual rate of college inflation for the most expensive college in the plan.
The most common type of prepaid tuition plan is a contract plan. With a contract plan, in exchange for your up-front cash payment (or series of payments), the plan promises to cover a predetermined amount of future tuition expenses at a particular college. For example, if your up-front cash payment buys you three years' worth of tuition expenses at College ABC today, the plan might promise to cover two and a half years of tuition expenses in the future. Plans have different criteria for determining how much they'll pay out in the future. Keep in mind that if your beneficiary attends a school that isn't in the prepaid plan, you'll typically receive a lesser amount based on a predetermined formula.
The other type of prepaid tuition plan is a unit plan. Here, you purchase units or credits that represent a percentage (typically 1 percent) of the average yearly tuition costs at the participating colleges. Instead of having a predetermined value, these units or credits fluctuate in value each year according to the average tuition increases for that year. You then redeem your units or credits in the future to pay tuition costs; many plans also let you use them for room and board, books, and other supplies.
529 plans are understandably attractive to those saving for college. They have a number of advantages including tax-deferred growth, federal tax-free earnings and favorable gift and estate tax treatment. 529 plans also offer variety and simplicity. Bear in mind though that these vehicles give you little control over your specific investments.
A final note to keep in mind: Make sure you understand what will happen if a plan's investment returns can't keep pace with tuition increases at the colleges participating in the plan. Will your tuition guarantee be in jeopardy? Will your future purchases be limited or more expensive?
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
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