There are many ways to save for college, but one thing is certain: it is never too early to start. One way to save for college is with a "Section 529" plan. These plans offer a way to pay for college expenses with some nice tax advantages.
What are they?
Section 529 plans allow you to set up a tax-advantaged account to pay for your child's college education. There are two types of Section 529 plans: prepaid tuition programs and college savings plans.
- Prepaid tuition programs let you lock in today's tuition costs by purchasing tuition credits or certificates that a student redeems when he or she starts college.
- College savings plans let you make contributions to a state-sponsored savings account to build a fund for your child's college expenses. These accounts are generally managed by a private mutual fund company. This is the Section 529 plan you've probably been hearing about, and it is this type of college plan that is the focus of this article.
How do Section 529 college savings plans work?
- Make a gift to set up an account. You start by setting up an account and naming your child (or anyone else) as the beneficiary. Your contribution is considered a gift. Your contributions qualify for the $14,000 annual tax-free gift exclusion ($28,000 for married couples making a joint gift).
Special rules for 529 plans let you average your gift over five years. This means married couples can make a $140,000 joint gift and individuals can make a $70,000 gift in a single year, without incurring gift tax. However, you cannot make additional gifts to your child for five years, or you may owe gift tax.
- Your contribution is limited. You aren't permitted to make contributions to a 529 plan beyond what is necessary to pay for your child's college expenses. Each plan sets its own limit.
Most plans allow you to make either a lump sum contribution or a series of monthly contributions. All contributions must be made in cash; you can't contribute shares of stock or other property to these plans.
- You remain in control. You cannot choose the investments in the fund - you must choose one of the plan's investment options. However, you do remain in charge of all withdrawal decisions. You can allow your child to make withdrawals to pay for college expenses. If your plan permits it, you can change the beneficiary to one of your other children. If you change your mind about maintaining the account, you can even request a refund (tax and penalties will apply).
- Your child can withdraw money to pay for college expenses. Section 529 funds must be used for qualified higher education expenses, such as tuition, fees, books, and supplies. They can also be used to cover certain room and board expenses, as long as your child attends school at least half-time. If your child receives a scholarship, you can request a penalty-free refund up to the amount of the scholarship. In addition, you can withdraw the funds if your child becomes disabled or dies.
If the funds are withdrawn for any other purpose, you (not your child) pay tax on the earnings that have accumulated in the fund.
- You can change plans. You can make a tax-free rollover to another plan with the same beneficiary. That allows you to move your child's plan to another state's plan without losing the tax benefits. This tax-free rollover treatment only applies to one transfer within any 12-month period.
What are the benefits?
- Section 529 plans offer tax benefits. Your contribution is not tax-deductible, but your investment grows tax-deferred. That allows your money to grow faster than a similar investment in a taxable account. Qualified distributions from Section 529 college savings plans are tax-free.
- Section 529 plans offer an estate planning opportunity. Section 529 plans let wealthy parents or grandparents transfer wealth out of an estate and into an account a child can use to pay for college expenses.
What are the disadvantages?
While these plans offer an attractive alternative to other college funding plans, they are not without drawbacks. There are a number of factors you should consider before you invest in a Section 529 college savings plan.
- Substantial penalties apply to nonqualified withdrawals. Any nonqualified distributions will be subject to withdrawal fees and penalties. You'll also owe income tax on the distribution.
- Your state plan may not meet your investment expectations. You should choose from among the available plans the one that meets your risk tolerance and performance expectations. But what if you are unhappy with a plan's investment performance? If your plan allows rollovers, you can move the funds into another plan. If you simply request a refund, you'll have to pay income tax and penalties on the distribution.
Do your homework.
The same federal income tax rules apply to all Section 529 college savings plans. However, each plan has unique features. Here are some items you should compare when you evaluate different plans.
- State income taxes.
- Investment return.
- Enrollment fees.
- Maximum contributions.
- Flexibility in making contributions.
- Withdrawal fees and penalties.
- Transferability to another beneficiary or another qualified plan.
- Choice of schools.
- Participation by nonresidents.
- Beneficiary age restrictions.
- Covered education expenses, including restrictions on room and board.
Section 529 plans provide an attractive, tax-favored way to save for college. However, they are not the right choice for everyone.