529 Plan

What is a '529 Plan'

529 is a category of plans that provide tax advantages when saving and paying for higher education. There are two major types, pre-paid tuition plans and savings plans. Pre-paid tuition plans allow the plan holder to pay for the beneficiary's tuition and fees at designated institutions in advance. Savings plans are tax-advantaged investment vehicles, similar to IRAs. Rules governing the plans are laid out in Section 529 of the Internal Revenue Code. They are legally referred to as "Qualified Tuition Programs" and sometimes called "Section 529 plans."

BREAKING DOWN '529 Plan'

There is no limit on the number of 529 plans an individual can set up, but contributions cannot exceed the cost of education. Distributions from all 529 plans are exempt from federal income taxes, although contributions are not deductible. Annual contributions of over $14,000 are subject to federal gift taxes.

The market for plans is competitive, and most states do not require the plan holder to be a resident or the beneficiary to attend an institution in the state. However, some pre-paid plans do have these requirements. States' plans generally offer their own tax benefits. For the most part these perks only benefit residents, but a few states match the benefits of whatever plan a resident opts for.

Eligible expenses vary depending on the plan. Tuition costs and mandatory fees can always be covered by distributions. Savings plans can be applied to room and board, textbooks and some computer equipment. A few pre-paid plans apply to room and board. 529 plans cannot be used to pay for student loans. Distributions that are not used to pay for qualified educational expenses are subject to taxes and a 10% fee, with exceptions for circumstances such as death and disability.

Ownership

The assets of a plan belong to the plan holder, not the beneficiary (although these can be the same person). The beneficiary has no claim on the assets, which can be withdrawn by the holder for any reason at any time, with penalties. A plan can be transferred to a member of the beneficiary's family, or excess funds can be rolled over into a family member's plan. Neither action triggers a penalty or taxes. Although the beneficiary does not control the plan's assets, these may affect his or her financial aid eligibility to a significant degree. The plan's assets are generally not counted as part of the plan holder's estate, so 529 plans confer estate tax benefits.

Savings Plans

Savings plans, which are only offered by states, are similar to IRAs in that they are tax-advantaged ways to invest money in the long term. Plan holders usually have the option to invest in a range of mutual funds. These funds may be targeted to the date beneficiary is expected to start their education and attempt to reduce risk exposure as the date approaches.

Pre-paid Tuition Plans

Pre-paid tuition plans are offered by states and higher education institutions. In a way, they're analogous to futures contracts: they allow the plan holder to prepay for one or more semesters at designated colleges or universities at current prices. This shields them from inflation in tuition costs, which has historically been much steeper than broader measures of inflation. 

Pre-paid plans differ in their specifics, but often have limitations that do not apply to savings plans, such as age caps and residency requirements. They often have stricter limits on what expenses they can cover: textbooks or room and board may not be eligible. On the other hand, some are guaranteed by states, while savings plans are subject to market risk.

There is one non-state pre-paid plan, called the Private College 529 Plan (formerly the Independent 529 Plan), which allows holders to prepay tuition for a consortium of private schools. One problem with this plan, as with state plans, is that the choice of schools is limited. If the beneficiary does not attend one of the selected schools, the funds may be rolled over into another plan, causing them to forfeit most of their gains. Alternatively, they can be transferred to a family member of the beneficiary or rolled over into that beneficiary's plans, which involves no penalty.

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