529 College Savings Plans: Online Guidebook

Over the past few decades, tuition rates at U.S. colleges and universities have consistently increased at between two and three times the average rate of inflation.(1) Throughout this same time period, options for student financial aid have been shifting away from grants toward borrowed funds, such as student loans.

In fact, approximately 60% of today's college and university students' federal financial aid is in the form of a loan.(2) This greatly increases the number of individuals who will enter into the workforce with a substantial amount of student loan debt.

While this may seem discouraging, there are options available to help to save some or all of the funds that may be needed to pay for a student's higher education tuition, including related expenses such as fees, books, and room and board.

One such option is the 529 college savings plan. In the less than 20 years that these plans have been available, it is estimated that nearly 9 million families have saved in excess of $100 billion for qualifying higher education related expenses.(3)

By using this guide, you will gain a better understanding of:

  • How 529 savings plans work and how to establish one
  • Who is eligible to establish and contribute to a 529 savings plan
  • The pros and cons of other types of college savings vehicles
  • How much may be contributed to a 529 plan
  • The tax advantages associated with 529 plans
  • The best time to set up a plan
  • How to take the next step in obtaining some – or all – of the funds that are needed to fulfill the dream of a higher education.

Additional resources can also be found at the back of this guide. This information can help you to find more details suited to your specific situation, allowing you to move forward with your higher education goals.

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Why Saving for College is Essential

Every year, the cost of higher education continues to skyrocket. With the average annual cost of a four-year, in-state public college (tuition, fees, and room and board) at nearly $18,000 for the 2012-2013 school year, and the cost of a four-year, private college approaching $40,000, the expense can be overwhelming.(4)

In fact, according to the Institute of Education Sciences, between the 2000-2001 and 2010-2011 school years, the price of undergraduate tuition, room, and board at public higher educational institutions rose 42%, and the price during that same time frame at private higher educational institutions increased by 31%, after adjusting for inflation.(5)

Finding the funds to pay for a college education can be difficult. In fact, next to saving for retirement, your biggest financial challenge may be finding the available funds for your child's future education.

The good news is there are options available for helping to save for such expenses – and one of the best, easiest, and most flexible methods for doing so is the 529 plan. These plans, created in 1996, can provide for some – or even all – of the higher education costs the account beneficiary will incur.

In addition, by saving for a child's higher education you are making an investment in his or her future. This investment can pay off in a number of ways, such as higher future earning potential. It can also allow the beneficiary to enter into the workforce without being strapped with a five- or six-figure student loan debt.

By opening a 529 plan, even just a little savings can go a long way in funding college education goals. But, in order to do so, it is essential to get started as soon as possible, as time is a key component in how much the plan's funds can grow.

"The good news is there are options available for helping to save..."
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What is a 529 Plan?

One of the best ways to help save for higher education expenses is through the use of a 529 college savings plan. These tax-advantaged accounts are specifically designed for college savings. They allow the account holder to invest in any state's plan and the beneficiary to use the funds at nearly any accredited higher educational institution in the U.S.

A 529 plan can be operated by either a state or educational institution. These plans help those who are saving for a future college or other post-secondary education to do so in a tax advantaged manner, as well as with other potential incentives.

529 plans can also allow for prepayment of certain expenses at eligible higher educational institutions. Officially titled Section 529 plans, these vehicles are named after the Internal Revenue code section that established them. They may also be referred to as "qualified tuition programs."

How 529 Savings Plans Work

A 529 plan can be an easy way to save money for college. These plans permit individuals to either prepay future tuition at a qualified educational institution at current tuition rates, or to invest funds into a tax-deferred account that will allow the money to be used for qualifying education expenses at future tuition rates.

With a state-sponsored 529 plan, the state sets up the plan and selects an asset management company of its choice, which creates a plan according to the state's requirements. Account holders then establish a plan directly with the asset management company.

A Brief History of the 529 College Savings Plan

Due in large part to the concern over excessive student loan debt, the United States Congress initially established 529 plans in 1996.(6) The development of these plans, along with their tax advantages, led to the creation of college savings plans across the U.S., and between 1996 and 2000, 30 states developed and launched their versions of the Section 529 plan.

Later, after passage of the Economic Growth and Tax Relief Reconciliation Act in 2001, additional congressional support was obtained for these plans, as this Act exempted the earnings in 529 plans from federal income taxation.(7)

Today, all 50 states, as well as the District of Columbia, offer 529 plans. As program enhancements and new investment options continue to be developed, the role of each state has become even more vital with regard to the 529 plan.

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What is a 529 Plan?
Types of 529 Savings Plans

There are two primary types of 529 savings plans: Prepaid tuition plans and savings plans. In addition, each state has its own plan – although states are allowed to offer both types of plans.(8) Plans that are offered through qualified educational institutions, however, may only be prepaid tuition plans.

  • Prepaid Tuition Plans - Prepaid tuition plans allow the prepayment of part or all of the future costs of an in-state public college. If necessary, these plans can be converted for use at a private and/or an out-of-state educational institution. There is also a Private College 529 Plan which is a prepaid higher educational savings plan specifically geared toward saving for the cost of a private college or university.(9)
  • Savings Plans - A 529 savings plan will work in a similar fashion to an IRA or 401(k) retirement savings plan in that the funds in the account can be invested in a variety of different financial vehicles. In these plans, the account value can rise and fall, based on the performance of the underlying investments that are selected.

Either of these options allows the account holder to earn interest on the underlying investments.

Comparing Prepaid Tuition Plans and Savings Plans
Prepaid Tuition Plan Savings plan
Locks in tuition prices at eligible public and private colleges and universities. No lock on college costs.
All plans cover tuition and mandatory fees only. Some plans allow a room and board option, or may allow use of excess tuition credits for other qualified expenses. Covers all "qualified higher education expenses," including:
  • Tuition
  • Room and Board
  • Mandatory Fees
  • Books
  • Computers (if required)
Most plans set lump sum and installment payments prior to purchase based on the age of the beneficiary and the number of years of college tuition purchased. Many plans have contribution limits in excess of $200,000.
Many plans are backed or guaranteed by the state. No state guarantee. Most investment options are subject to market risk. Investment may make no profit or may even decline in value.
Most plans have age and/or grade limits for the beneficiary. No age limits. Open to adults and children.
Most plans require either the account holder or the beneficiary to be a state resident. No residency requirement. However, nonresidents may only be able to purchase some plans through financial advisors or brokers.
Most plans have a limited enrollment period. Enrollment is open all year.

Source: "Smart Saving for College," NASD.

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What is a 529 Plan?
Who Controls the Account?

The person who actually establishes the 529 plan is also considered to be the account's custodian. It is this individual who will control the funds within the account until the funds are withdrawn. This differs from other types of custodial accounts where the beneficiary attains control of the funds when he or she reaches a certain age.

Where Can 529 Plans Be Established?

Because 529 savings plans have no residency requirements, an individual may invest in any state's plan. Further, the assets in a 529 plan may be used to pay for higher education in any state.

A 529 college plan may be opened through any state higher educational savings website, or through a professional financial advisor licensed to offer these types of plans.

How Do Plans Differ from State to State?

Even though most plans follow the same general outline, because each state is allowed to control some of the features of their own 529 plans, there are variations in plans from one state to another.

In addition, some states offer more than one type of 529 plan, so it is important to compare all plans offered by the state, as well as other states' plans, in order to determine which plan may be best for one's specific college funding needs and educational goals.

The Many Advantages of 529 Savings Plans

There are many advantage to establishing a 529 plan, the biggest of which is that earnings within the plan are not subject to federal income tax. In addition, such earnings may also be exempt from state income tax when they are used to pay for certain qualified education expenses for the account beneficiary.

Qualifying expenses include:

  • Tuition
  • Fees
  • Books
  • Room and Board
  • Computers (if required)

Benefits of 529 savings plans include:

  • Tax Advantages - Although contributions to a 529 plan are not tax deductible, the funds within the account are allowed to grow on a tax-deferred basis. In addition, distributions made to the account beneficiary for qualifying expenses come out of the account federally tax free. Because of this, even if the funds are used for other purposes, the account holder is required to report earnings on the underlying assets until the year they are withdrawn. Some states also offer additional tax breaks.
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What is a 529 Plan?
  • Low Maintenance - It is easy to set up and contribute to a 529 plan. In addition, the ongoing administration of these accounts is handled by the plan, and the plan's assets are professionally managed by an investment company or by the office of the state treasurer.(10)
  • Low Impact on Other Financial Aid - Because the funds inside a 529 plan are considered to be parental assets, the amount is factored into federal financial aid formulas at a maximum rate of approximately 5.6%. This means that only this percentage of the 529 plan's assets will be included in the Expected Family Contribution that is calculated in the federal financial aid process.
  • Flexibility - 529 plans allow the flexibility of moving the plan's assets to another type of plan if the account holder so chooses.
  • Eligibility - Nearly anyone is eligible to participate in a 529 plan. There are no income or age restrictions, and the amount that may be contributed to a plan is substantial.
Comparing 529 Plans to Other College Savings Options

While there are other college savings options available, the 529 plan seems to offer a great deal more benefits and flexibility. For example, the Uniform Gift to Minors Act, or UGMA, allows individuals to donate financial gifts to minors for many purposes, including higher education expenses. In this case, a custodian is chosen to manage and invest the donated funds until the minor reaches a certain age (usually 21).

The Uniform Transfers to Minors Act, or UTMA, is an extension of UGMA in that it allows assets other than cash or securities to be considered gifts to the minor. While both Acts have certain benefits, the process of setting up such accounts can be costly and complicated.

Coverdell Education Savings Accounts, or ESAs, are also savings accounts for higher education expenses. With these accounts, however, the contribution limit per beneficiary is capped at $2,000 per year (in 2013).(11) There are also contribution limits for donors, based on the contributor's modified adjusted gross income. In addition, the contributions to these types of accounts are not tax deductible.

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What is a 529 Plan?
Comparing Prepaid Tuition Plans and Savings Plans
Features 529 College Savings Plan UGMA/UTMA Coverdell Education Savings Account
Earnings in the account grow on a tax-deferred basis, and qualified distributions are free of federal income tax. X A portion of the earnings may be tax exempt. X
High annual exclusion transfer tax limits. X (with some restrictions) $14,000 per year for an individual, or $28,000 per year for a married couple. $2,000 annual limit on contributions.
Beneficiary may be changed. X X
The account owner maintains control over the plan distributions. X The plan's distributions must be used for the student. X
No income restrictions on the account holder. X X May not contribute if Adjusted Gross Income is more than $110,000 annually for a single tax filer, or $220,000 for joint tax filers.
Low impact on financial aid qualification. X X
Choice of underlying investments. X* Portfolio's investment choices may be managed by professional fund manager. Account owner/custodian must choose the investments. Account owner must choose the investments.

Source: The ABC's of 529 College Savings Plans
https://www.fidelity.com/viewpoints/abcs-of-529-college-savings

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What is a 529 Plan?
When is the Best Time to Establish a 529 Savings Plan?

The best time to establish a 529 savings plan is sooner rather than later. This will allow a longer time horizon for funds to grow. And the more time you allow for contributions before the beneficiary attends college, the smaller the contribution amounts can be–with the same overall financial impact.

Over time, a little goes a long way.

Source: Why Save for College? - Cost of College and Saving for College - CSPN

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How Can 529 Plan Funds be Used?

Funds within a 529 college savings plan may be used for virtually any purpose. However, in order to be qualified for tax-free withdrawals on the earnings, the money must be used for qualified higher education expenses for the account beneficiary at an eligible educational institution.

How Can the Funds in a 529 Savings Plan be Used?

To qualify for tax-free distributions, the funds in a 529 savings plan should be used for paying the account beneficiary's qualified education expenses. These expenses include:

  • Tuition
  • Fees
  • Books
  • Room and Board
  • Computers (if required)

*Note: Beginning in the 2009-2010 school year, a qualified, nontaxable distribution from a 529 savings plan could be used for the cost of purchasing any computer technology, related equipment, and/or related services such as internet access. These expenses will qualify as if they are used by either the plan's beneficiary, or the family of that individual, throughout the school year, as long as the plan beneficiary is enrolled at an eligible educational institution.(12)

If it turns out that the account beneficiary will not be using the funds for higher education expenses, there is some flexibility in how the money can ultimately be used. In addition, funds may be withdrawn at any time for non-educational expenses if necessary. The earnings on the withdrawn funds, however, will be taxed, along with an additional federal tax penalty of 10%.

Determining an Eligible Educational Institution

Per IRS rules, an eligible educational institution is generally any college, university, vocational school, or other post secondary educational institution that is eligible to participate in a student aid program administered by the United States Department of Education. (13)

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Who is Eligible to Have a 529 Plan?

A 529 college savings plan offers a great deal of flexibility as to who can establish and contribute to the account, as well as who is eligible to be the account's beneficiary.

Qualified Account Holders and Beneficiaries

According to the Internal Revenue Service, anyone may set up a 529 savings plan. In addition, anyone may be named as the beneficiary of such a plan, including the account holder.

Account beneficiaries are typically current or future students for whom the 529 savings plan is intended to provide benefits. There may only be one beneficiary designated per 529 plan account.

Although the plan's beneficiary is typically not limited to attending a school in his or her state, it is important to check with the plan being considered to ensure this is the case. The 529 account beneficiary may be changed to another qualifying individual if desired.

In addition, more than one 529 plan may be established by an individual. And, unlike certain types of retirement accounts, there are no income restrictions placed on the account holder or the beneficiary in terms of establishing a 529 plan.

State Incentives for Obtaining College Savings Plan Participants

When choosing a 529 plan, it is important to note that some states offer various incentives to residents who invest in their home state's plan(s). Such incentives may include:

  • Tax deduction or credit on account contributions
  • Waiving of the plan enrollment fee if a plan is established before a certain date
"...unlike certain types of retirement accounts, there are no income restrictions placed on the account holder or the beneficiary in terms of establishing a 529 plan."
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Contributing to a 529 Plan

Compared to other types of college savings plans, the 529 savings plan rules are more liberal with regard to contributor's annual income limit as well as yearly deposit limits.

529 Savings Plan Contribution Limits

529 savings plans have yearly contribution limits. Based on IRS stipulations, these limits are based upon the amount considered necessary to provide for the beneficiary's qualified education costs. This rule is intended to keep plan contributors from "over funding" the account.

In many states, annual contributions of $200,000 or more are allowable. On the other hand, a minimum contribution amount of $25 or $50 per month is typically required in order to keep the plan in force.

There could be gift taxes due on the contributed funds – combined with any other gifts to the plan beneficiary – that exceed the annual gift tax exemption amount of $14,000 (in 2013).(14) However, it is allowable to contribute up to five years worth of gifts during the first year of a 529 college savings plan.

529 Plan Contribution Guidelines (2013)
Amount Circumstances
$14,000 ($28,000 if from married couple) Amount that may be contributed without incurring gift taxation.
$70,000 ($140,000 if from married couple) A one-time, 5-year accelerated gift contribution may be made

A state's contribution limit will apply to either type of 529 plan. For a prepaid tuition plan, the state's contribution limit is the limit on the total amount of contributions. As an example, if the state's limit is $300,000, then an individual cannot contribute more than that amount.

Note, however, that contribution limits generally do not cross state lines. Therefore, the contributions that are made to one state's 529 plan don't count toward the contribution limit in another state.

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Contributing to a 529 Plan
Who is Eligible to Contribute?

For the most part, anybody is eligible to both establish and contribute to a 529 plan on behalf of the account's designated beneficiary. This means that family, friends, acquaintances, and even the beneficiary may all make contributions.

There are, however, certain participation rules that may vary by state. For example, some states limit plan establishment to only residents of the particular state. Therefore, it is important to check with the financial or educational institution through which the plan is established in order to determine who is and is not eligible.

Eligible Investment Options

The underlying investments in a 529 plan will depend upon which type of plan the account holder establishes. For example, prepaid tuition plans will typically allow the account holder to purchase "credits" or "units" at participating educational institutions for future tuition. (In certain cases, credits or units may also be purchased for future room and board). Because most prepaid tuition plans are backed by states, the investments within these plans are usually guaranteed.

A savings plan, however, will typically allow the account holder to open an account for the beneficiary. There are many financial vehicles available for investment in a savings plan, including a variety of mutual funds, as well as certain types of age-based portfolios that will automatically shift to more conservative investments as the beneficiary approaches the time that he or she will need to withdraw the funds. In many cases, the account holder may even change the investment options once each calendar year. (15)

"There are many financial vehicles that are available for investment in a savings plan."
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529 Plan Tax Considerations

In addition to helping beneficiaries save for a college education, a 529 plan can also offer certain tax advantages. One of the biggest tax-related benefits is that the earnings within a 529 savings plan can grow on a tax-deferred basis. This means that tax is not due on this money until the time it is withdrawn. However, if funds are used for qualifying educational expenses, the money may be taken out tax-free.

If money from the plan is withdrawn and not used on eligible college-related costs, the account holder is subject to income taxation on the funds, as well as an additional federal tax penalty of 10% on the earnings.

While there are some states that provide deductions or other tax-related benefits for investing in a state-sponsored 529 plan, an account holder may only be eligible for such benefits if they participate in a plan that is sponsored by their own resident state.

In addition, there are some states that allow residents to deduct 529 plan contributions from their state income tax return. Contributions to such plans are not deductible from a federal income tax standpoint.

There may be instances where the investments within a 529 savings plan are performing poorly and result in an investment loss. In these situations, such a loss will not be tax-deductible at the time the loss is incurred.

A loss may be claimed only when all amounts from the plan have been distributed and the total amount of these distributions is less than the original contribution amount. In this case, the loss would be claimed as a miscellaneous itemized deduction on Schedule A of Form 1040. In addition, this loss would be subject to the 2% of adjusted gross income limit.

Gift Tax Considerations

Contributions to 529 plans are considered gifts, and are therefore subject to gift taxation. In 2013, an individual may contribute up to $14,000 to a plan (and a couple may contribute up to $28,000), and the gift will remain exempt from gift taxes. In addition, during the first year of a 529 plan, up to five times the amount of the gift tax limit – or $70,000 ($14,000 X 5, in 2013) – may be contributed and treated as if the contribution were made over a five-year time period for gift tax purposes. This provides a big incentive to begin the plan with a larger amount of contributed funds.

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Starting a 529 Plan

When choosing the right 529 college savings plan, there are several factors to consider. These should include:

  • Examining the plans that are offered in various states to determine which may work best for specific college funding needs;
  • Researching the manager of the particular plan (or plans) of interest in order to get an idea of the individual's (or individuals') past performance;
  • Inquiring about any fees the plan may charge;
  • Considering the types of investment shares that may be purchased within the plan;
  • Checking for any age limitations, as some states require the beneficiary use the funds prior to reaching a certain age or within a particular time limit;
  • Determining how much will be needed in the account for the beneficiary's educational expenses in the future;
  • Understanding how and when withdrawals may be made.
How to Open a 529 College Savings Plan

There are two primary ways to establish a 529 plan. One method is to open an account directly via a state's college savings program website. Each state offers online information regarding how to both research and select a plan, as well as an enrollment checklist and account forms.

Accounts may also be opened through a financial advisor who offers such plans. There are many financial professionals who specialize in these types of plans and can directly answer any questions regarding plan establishment, contributions, and withdrawals.

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Find State Specific 529 Information
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Additional Resources

There are a number of resources available that can help you determine the next step in establishing a 529 plan, as well as answer any additional questions you may have related to this topic.

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Glossary of Terms
  • 529 Plan- A type of tax-advantaged investment program that is designed to assist with saving for college expenses. The name of this program is derived from the IRS code section that established these plans. A 529 plan may also be referred to as a qualified tuition plan or a 529 college savings plan.
  • Account Owner - The person who has established the 529 plan account and who also controls the assets held in the account on behalf of the plan beneficiary. The account owner may also be referred to as a participant.
  • Age-Based Portfolio - A portfolio in which the investments are automatically adjusted to become more conservative as the beneficiary approaches college age.
  • Asset Allocation - The process of spreading out investments in an account among various classes of assets such as stocks, bonds, and cash. This typically helps in the optimization of a risk/reward tradeoff.
  • Automatic Investment Plan - This process allows an account holder to make regular investments via regular automatic debits from a savings or checking account
  • Beneficiary- The person for whom the 529 savings plan has been established. The beneficiary is allowed to use the assets in the plan for higher education expenses, but does not have control over such assets.
  • Bond - A type of debt instrument that is issued by a company or government for the purpose of raising capital. The purchaser of a bond has an interest in – and a claim to – the issuer of the bond's assets.
  • Contribution - The funds that are invested into a 529 savings plan.
  • Earnings - The growth that has been generated by an investment.
  • Eligible Educational Institution - An educational institution must be considered "eligible" in order to use the funds within a 529 savings plan without incurring tax penalties. Typically, this will be a post-secondary institution that offers credit toward a degree or credential. There are also certain vocational and trade institutions that may qualify. In addition, an institution must be eligible to participate in a student financial aid program under Title IV of the Higher Education Act of 1965.
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Glossary of Terms
  • Exchange - This law allows 529 savings plan account holders to make changes to the investment choices within their plan one time per calendar year. This is also referred to as the annual investment exchange.
  • Individual Portfolio - An individual portfolio is a type of static asset investment vehicle that is used in 529 savings plans. A 529 plan account holder may typically create his or her own diversified portfolio from among the plan's choices.
  • Member of the Family - The beneficiary of a 529 savings plan may be changed to an approved member of the family without incurring a tax penalty. However, this individual must meet qualification criteria as specified in IRS Code Section 529. A member of the family refers to an individual who is related to the beneficiary in one of the following ways:
    • Mother, father, or an ancestor of either
    • Daughter, son, or a descendant of either
    • Stepfather or stepmother
    • Stepson or step daughter
    • Sister, brother, step sister, step brother, half sister, half brother
    • Sister-in-law or brother-in-law
    • Daughter or son or a brother or sister
    • First cousin
    • Spouse of the beneficiary, or spouse of any of the above
  • Non-Qualified Withdrawal- Funds within a 529 savings plan may be withdrawn for purposes other than for the beneficiary's qualified higher education costs. These withdrawals are referred to as non-qualified withdrawals. The earnings on such withdrawals will be subject to federal, state, and local income taxation, and they may also be subject to an additional federal penalty tax of 10%.
  • Prepaid Plan - A type of 529 savings plan where the contributions to the plan go toward the cost of enrolling in a college. These plans may be limited to in-state educational institutions. This differs from an actual college savings plan where the assets may be used at any eligible institution in the country.
  • Qualified Expense - In order to use the funds in a 529 savings plan without incurring taxes, the expense must be considered to be qualified. Such expenses include tuition, fees, and the cost of books, supplies, and any other equipment that may be necessary for the enrollment or the attendance of the beneficiary at an eligible educational institution. There are some room and board costs that may also be considered as qualified. A qualified expense may also be referred to as a qualified higher education expense.
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Glossary of Terms
  • Rollover - The movement of funds from one investment account into another, such as rolling over funds from an UGMA/UTMA account into a 529 savings plan account.
  • Savings Plan - 529 savings plans work in a similar fashion to an IRA or 401(k) retirement savings plan in that the funds in the account can be invested in a variety of different financial vehicles. In these plans, the account value can rise and fall, based upon the performance of the underlying investments that are selected.
  • Tax-Deferred - The ability of investment earnings and growth to be delayed until a later time. Funds within a 529 savings plan grow on a tax-deferred basis, and when withdrawn for the purpose of paying for qualified higher education expenses, may also be tax free.
  • UGMA/UTMA - The Uniform Gift to Minors Act and Uniform Transfer to Minors Act allow an adult to contribute funds to a custodial account in the name of a minor. A custodian will then be responsible for the account until the time the minor reaches legal age. At that time, the former minor may control the assets in the account.
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Sources
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