The 529 account: Get a tax break while saving for college

college savings plans

Even if receiving a college acceptance letter in the mail is years away, you can still start saving for college with a 529 plan. Named after the section of the Internal Revenue Code that covers them, these programs were developed to encourage people to save for college. They are sponsored by states and administered by the state treasurers, the schools or investment companies. Funds are typically invested in stocks, bonds and mutual funds. Anyone can contribute to a 529 plan -- there are no income restrictions and you don't have to be related to the beneficiary. When the beneficiary is ready for college, the money can be withdrawn and used for qualified educational expenses.

What are the benefits of a 529 plan?

Section 529 plans offer a number of advantages to contributors:

  • Freedom from federal taxes. Contributions are not deductible on your federal tax return, but the accounts' earnings are not taxed at the federal level.
  • Possible state tax benefits. Your home state may also offer tax breaks if you sign on to its plan. These can include an upfront deduction for your contributions, taxing benefits at your child's rate instead of yours or complete exemption from taxation of the withdrawals. If investing in your state's plan doesn't confer any special benefits, says Steve George, Chief of Staff at the Nevada State Treasurer's office, look at plans from other states as well, and choose one that performs well and offers the features you want.
  • Control. Unlike some trust funds or custodial accounts, 529 plans allow you total control over the funds. You can roll the funds into different state's plans, switch beneficiaries, or reclaim the money yourself if junior doesn't turn out to be college material. However, the earnings portion of such a withdrawal is subject to income tax and an additional 10 percent penalty.

What kinds of plans are there?

Section 529 plans come in two guises -- prepaid tuition plans and college saving plans. They each offer different advantages and limitations.

  • Prepaid tuition plans. These involve buying credits at a public college or university at current prices. With college tuition prices increasing at a rate that exceeds inflation or the rate of return on many investments, this is a good plan for conservative investors. No matter what increases occur in tuition rates in the future, the quarters/semesters/years purchased at current prices are guaranteed for the future. The state assumes the risk of paying those costs later at whatever price that might be -- but only if the beneficiary attends an in-state school. Some plans cover only tuition and fees, while others may include room and board, as well. What happens if your student chooses to go to college at a private school or in another state? States don't guarantee that the credits purchased will cover tuition elsewhere or at a private institution. You may just get back your contributions and some small amount of interest.
  • College savings plans. With these plans, saving for tuition means contributing to a tax-advantaged account similar to an IRA. You may get to choose the investments from a list provided by the plan administrator. In some college savings plans, the investment options change with the age of the beneficiary -- you'd want to choose safer investments as the student nears college age, and take more risks for higher returns when the student is younger. Unlike prepaid tuition plans, there is no guarantee that the funds will be sufficient to cover the beneficiary's education. You shoulder the risk, so the amount available for education expenses will be affected by the rate of return on the investments. College savings plans can be used to pay qualified expenses at any eligible institution.

What colleges are eligible?

Qualifying institutions must be accredited and eligible to participate in a student aid program administered by the U.S. Department of Education. They may be public, private or for-profit schools. They can be universities, colleges, vocational schools or other post-secondary institutions.

Where do you find plans?

You can find your state's plans by checking with the state treasurer's office or its website. If investing in your state's plan doesn't get you any special tax breaks, you'll want to compare plans from other states and choose one with a track record of excellent performance. Nevada, for example, offers exceptional plans to investors regardless of where they live. Steve George says, "Nevada provides an impressive array of plans to suit any parent's pocketbook, from our low price national Upromise College Savings Fund for those on a tight budget to premium advisor-sold plans to those designed for our military heroes. Two of Nevada's plans, Vanguard and USAA, are ranked in the top 10 nationally for performance." You can ask your investment advisor or visit sites, such as SavingForCollege.com, which ranks plans based on their historical returns.

What if…..

What if your child decides to join a commune and write bad poetry instead of heading to college? What if you contributed enough for your daughter to go to Harvard and she opted for beauty school? What if your formerly wayward son unexpectedly wins a scholarship?

Few things are less predictable than teenagers, and the IRS understands this phenomenon. If your child decides college isn't her thing, you can move the funds into a sibling's account or designate another beneficiary with no penalty. In the unlikely event that any money remained after all your children were educated, you could let them use it for grad school, use it yourself, transfer it to another family member, or take it back and pay income taxes on the earnings plus a 10 percent penalty.

If your student chooses a cheaper school than you planned on, there will still be plenty of bills that qualify for tax-free withdrawals from the 529 plan -- including required fees, books, supplies and equipment. As long as your daughter attends school at least half-time, room and board count, too. And if she lives off campus, you can take a qualified withdrawal up to the cost of on-campus housing at that institution.

If your child is lucky enough to win a scholarship, you can take a penalty-free withdrawal from the 529 account up to the amount of the award. You would, however, have to pay federal and state income tax on the earnings portion of the withdrawal. So if your contributions totaled $20,000 and the account earned $5,000 in interest, one fifth of your withdrawal would be subject to tax.

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