An Introduction to 529 Plans

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future educational costs. 529 plans, legally known as qualified tuition plans, are authorized by Section 529 of the Internal Revenue Code. Withdrawals used for qualified educational expenses are tax free and can be used at any accredited college or university for full-time undergraduate and graduate students.

In 2017 the law was changed and now withdrawals used for qualified educational expenses include up to $10,000 annually of 529 savings that can be used for private school K-12 tuition.

All 50 states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a prepaid tuition plan.

There are 2 types of 529 plans:

  1. Prepaid tuition plans
  2. College savings plans (also called qualified tuition plans)

How does a prepaid tuition plan differ from a college savings investment plan?

A prepaid tuition plan allows you to purchase college units or credits, and in some cases room and board, for future enrollment at a college or university that participates in the plan. According to the Financial Industry Regulatory Authority (FINRA), most prepaid tuition plans allow you to prepay tuition at participating colleges at today’s price. With the cost of tuition rising each year, this can provide big savings. However, it is important to keep in mind that many plans require you or your student (the beneficiary) to be a resident of the state that sponsors the plan. Additionally, prepaid tuition plans have a limited enrollment period each year.

There are two main types of prepaid tuition plans:

  1. Prepaid Unit: Prepaid unit plans sell units that represent a fixed percentage of tuition, with 1 unit typically corresponding to 1% of a year’s tuition. Everybody pays the same price for the units and the price of a unit increases each
  2. Contracts: Contract plans sell contracts, where the parent agrees to purchase a specified number of years of tuition. The purchase price depends on the age of the child and on the type of payment (lump sum or installment). Contract plans usually offer lower prices for younger children, since the state has more time to invest the money.

College savings plans permit the account-holder to establish an investment account on behalf of a student for his or her future eligible educational expenses.

There are 2 types of plans:

  1. Advisor-sold
  2. Direct investment (in which the accountholder assumes responsibility for managing the investment)

An account-holder typically chooses among several investment contribution options, which the plan management firm then invests. Investment options include stock mutual funds, bond mutual funds, and money market funds. Investments are not guaranteed by state governments or federally insured.

Prepaid Tuition Plans
Only 12 States
College Savings Plans
All 50 States
Investment locks in tomorrow’s tuition prices today (at accredited schools). Some states offer only a direct investment plan; some states offer only a broker-sold plan; some offer both. No locking-in of college costs. Investment returns may match, be above or be below the rate at which tuition increases.
All plans allow tax-free withdrawals to cover tuition and mandatory fees. Some plans allow purchase of a room and board option or provide the ability to use excess tuition credits for other qualified expenses. Withdrawals tax-free to cover qualified higher education expenses including tuition; room and board, mandatory fees, books, computer, and software for educational purposes.
Most plans set lump sum and installment payments prior to purchase based on age of beneficiary and the number of years of tuition purchased. Many plans have contribution limits (for example, $200,000 per student).
Value is guaranteed or backed by the state, directly or indirectly. No guarantees. Investors are subject to market risk. Investments may appreciate or lose value.
Most plans have age or grade limits for the beneficiary. No age limits. Open to adults as well as children.
Most plans require either owner or beneficiary to be a resident of that state. No residency requirements. Non-residents may be able to purchase some plans only through financial advisors or brokers.
Most plans have a limited enrollment period. Enrollment open all year.

The SECURE Act

The SECURE Act (Setting Every Community Up for Retirement Enhancement) made several important changes to 529 plans. Now, families can use up to a lifetime limit of $10,000 of excess money in a beneficiary’s account to take a tax free distribution for the beneficiary’s student loan repayment. Plus, another $10,000 per sibling can be used to repay student loans held by the beneficiary’s siblings. Both principal and interest on an education loan are now considered a qualified 529-plan expense.

The SECURE Act allows 529 funds to be used for apprenticeship programs, which may offer college credits as well as job training. Covered expenses include fees, books and equipment such as required tools for the apprenticeship. The program must be registered and certified by the U.S. Labor secretary under the National Apprenticeship Act.

These changes under the SECURE Act apply retroactively to distributions made after Dec. 31, 2018.

What are the tax benefits?

Investing in a 529 plan offers special tax benefits. Earnings in 529 plans, including interest and dividends, are not subject to federal tax (and, in most cases, state tax) so long as you use withdrawals for eligible educational expenses.

However, if you withdraw money from a 529 plan and do not use the funds for eligible educational expenses, you will have to pay a tax penalty of 10% on the plan’s earnings

State tax treatment varies. Only a few states allow residents to deduct contributions to any 529 plan. Most states limit tax benefits on contributions and earnings to participation in their own state’s 529 plan.

If you receive state tax benefits, make sure you review your plan’s offerings before you complete a transaction (such as rolling money out of your home state’s plan into another state’s plan). Some transactions may have negative state tax consequences.

What fees and expenses can be expected?

Fees and expenses vary. Prepaid tuition plans typically charge enrollment and administrative fees. In addition to loads (commissions) for broker-sold plans, college savings plans may charge enrollment fees, annual maintenance fees, and asset-management fees.

Some of these fees are collected by the state sponsor; some fees are collected by the financial service management firms that the states hires. Some college savings plans will waive or reduce some fees if you maintain a large account balance, participate in an automatic contribution plan, or are a resident of the state sponsoring the plan. The asset management fees will depend on the investment option that you select.

Each investment option will typically bear a portfolio-weighted average of the fees and expenses of the selected mutual funds and other investments. You should carefully review the fees of the underlying investments because they usually differ for each investment option.

Investors who purchase a college savings plan from a broker are typically subject to additional fees. If you invest in a broker-sold plan, you may pay a sales commission. Your broker typically receives all or most of these annual distribution fees for selling your 529 plan to you. Many brokersold 529 plans offer more than one class of shares, which impose different fees and expenses.

Can we avoid extra fees?

Direct-sold college savings plans: many states offer college savings plans through which account-holders can invest without paying a load fee or sales fee. This type of plan, which you can buy directly from the plan’s sponsor or program manager, is generally less expensive because it waives or does not charge sales fees.

Broker-sold college savings plans: if you prefer to purchase a broker-sold plan, you may be able to reduce the front-end load if you invest above certain amounts.

Disclaimer:
This publication is designed to provide general information regarding the subject matter covered. It is not intended to serve as legal, tax, or other financial advice related to individual situations. Because each individual’s legal, tax, and financial situation is different, specific advice should be tailored to the particular circumstances. For this reason, you are advised to consult with your own attorney, CPA, and/or other advisor regarding your specific situation.

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