What is a 529 Plan? Part I

A 529 plan is a college education tax-advantaged plan. College savings plans are meant to encourage the saving of funds for college costs. 529 college plans, are “qualified tuition plans,” sponsored by educational institutions, states, or state agencies. The college plans are named after Section 529 of the Internal Revenue Code.

The two types of 529 investment plans are pre-paid tuition plans and college savings plans. All the states sponsor 529 plans and a group of private colleges and universities sponsor a pre-paid tuition plan.

Differences between Pre-paid Tuition Plans and College Savings Plans

Pre-paid tuition plans permit purchase of units or credits at participating higher education institutions for future college tuition at today’s cost, locking in current tuition rates. In addition to tuition, credits can be bought for room and board. Majority of the state sponsored prepaid tuition plans have residency requirements. State sponsored governments guarantee the underlying investments in their pre-paid tuition plans.

College savings plans establish an account for a “beneficiary” the future college student for the purpose of paying college expenses. The plan has several investment options (similar to mutual funds) to invest in; contributions can be allocated by the investors as desired within the choices offered. The underlying Investments include stock mutual funds, money market funds, and bond mutual funds, as well as, age-based portfolios.

The most convenient investment choice is the age based portfolio which automatically becomes more conservative as the beneficiary gets closer to college age. 529 savings plan withdrawals are only meant to be used for the beneficiary’s college savings plans. Unlike the pre-paid tuition plans, college savings plan Investments aren’t’ guaranteed nor federally insured.

The following chart outlines some of the major differences between pre-paid tuition plans and college savings plans.

Source: Smart Saving for College, FINRA

Federal Tax and State Income Tax Consequences of 529 plans

529 savings plan offer special tax benefits. The investment earnings in 529 plans aren’t subject to federal tax, and in majority of cases, state tax, if withdrawals are used for qualified college expenses. But, college funds withdrawn from the 529 college savings plan early or not used for qualified college expenses are subject to income tax and additional 10% federal tax penalty on earnings.

Most states provide state income tax or other benefits including matching grants. Some states allow deductions from their state taxes for any 529 plan contributions.

Continued 529 Plan II