Since its creation under the Small Business Job Protection Act of 1996, the Section 529 plan has become much more popular than other education-saving vehicles such as education savings bonds and the Coverdell Education Savings Account. However, despite its popularity, there is still confusion, which has led some people to establish the wrong type of 529 plan. In this article, we highlight some of the significant features of two types of 529 plans and discuss the factors that will help you choose the plan that's right for you.
529 Plan Defined
A 529 plan, also known as a "qualified tuition program", is an investment vehicle that allows individuals to save for education expenses at an eligible education institution. Eligible education institutions include any college, university, vocational school or other post-secondary educational institution eligible to participate in a student aid program administered by the Department of Education; this includes virtually all accredited public, nonprofit and proprietary (privately owned, profit-making) post-secondary institutions. Earnings in a 529 plan are tax free if used for qualified education expenses. While there is no residency restriction for establishing some 529 plans, tax deductions for contributions to a state's 529 plan can be claimed only by residents of that state. However, you should be aware that not every state allows deductions for 529 plan contributions.
A 529 plan may be established by anyone, including non-relatives, for a designated beneficiary. But contributions should not exceed the limit as set by the state. So, if a plan has more than one contributor, these contributors should inform each other of their contributions to ensure they don't exceed the limits. (For related reading, see Investing In Your Child's Education.)
Two Types of 529 Plans
Before choosing a 529 plan, be aware of the two major types: the college savings plan and the prepaid tuition program.
College Savings Plan
Under a college savings plan, amounts are contributed up to the dollar limit of the plan. Investors may be allowed to choose the investments from a list provided by the plan manager. In some college savings plans, the investment options are age based, with the most risky investments made available to younger individuals. Since the investor bears the risks of the investments, the amount that is eventually available for eligible education expenses will be affected by the rate of return on the investments.
The assets in a college savings plan may be used to cover eligible expenses at any eligible educational institution.
Prepaid Tuition Program
Under a prepaid tuition program, eligible expenses for a fixed period of time or a fixed number of credits are prepaid at an eligible educational institution. For example, an individual may make prepayments for two future semesters of college at today's cost. The prepayment guarantees the beneficiary two semesters, regardless of the cost in the future. This means that the program manager bears the risks of the investments. Contributions are limited to amounts necessary to pay the beneficiary's qualified education expenses.
Unlike the assets in the college savings plan, which can be used to pay qualified expenses at any eligible educational institution, assets in a prepaid tuition program are usually used toward expenses at a predetermined educational institution, or an educational institution from a predetermined list. Should the beneficiary decide to attend an educational institution that is not included in the predetermined list, the current market value of the prepayments may not be sufficient to cover the cost of comparable tuition at the other educational institution. This means that the beneficiary may need to cover the difference out of pocket.
The following are some additional comparisons between a college savings plan and a prepaid tuition program.
Choose the Right Type of 529 Plan
The type of plan you choose - whether a college savings plan or a prepaid tuition program - is generally determined by what features and benefits you find attractive. For instance, do you want the beneficiary to be free to choose an educational institution that is to his or her liking, or are you happy to have the beneficiary attend an institution chosen from a predetermined list?
Furthermore, you should examine the range of plans or programs available for each type of 529 plan. For example, if you decide that you prefer to establish a college savings plan, you should compare the features and benefits of the college savings plan offered by your state of residence with those of the plans offered by other states. Some features that you'll want to compare include investment choices, fees and other expenses, restrictions and/or limitations of the plan (such as rules regarding the changing of beneficiaries or investment choices), and whether the plan allows for rollovers from other education savings programs.
Regardless of what 529 plan you choose, the important thing is that you make a choice and start early. For college savings plans, starting early increases the compound effect of the earnings on contributions. And for prepaid tuition programs, the cost of tuition is usually less if prepayments are made earlier. You may want to talk to other family members and close family friends before you establish a plan, since they too may be planning to contribute to a 529 plan for the same beneficiary. Discussing the matter beforehand will help to prevent excess contributions from occurring. Most importantly, talk to your financial professional: he or she can help you make the choice that is best suited to your goals and your family's financial profile.
To read more, see A 529 Plan Fit For An Ivy League Education.