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Frequently asked questions about 529 plans

What is a 529 plan?
It's an education savings plan operated by a state or educational institution designed to help families set aside funds for future college costs. As long as the plan satisfies a few basic requirements, the federal tax law provides special tax benefits to you, the plan participant (Section 529 of the Internal Revenue Code).

529 plans are usually categorized as either prepaid or savings, although some have elements of both. Every state now has at least one 529 plan available. It's up to each state to decide whether it will offer a 529 plan (or possibly more than one), and what it will look like. Educational institutions can offer a 529 prepaid plan but not a 529 savings plan (the private-college Independent 529 Plan is the only institution-sponsored 529 plan thus far).

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Can I contribute the maximum amount in more than one state if I want to?
The IRS currently does not require that states count your investment in other state 529 plans when applying their own contribution limits. And there are no "contribution police" out there looking for people who are intent on using multiple states to stuff hundreds of thousands of dollars into 529 plans as a kind of tax shelter. But you are looking for trouble if you contribute more on an aggregate basis than you can reasonably argue might be needed for your beneficiary's future higher education costs. Of course, between a pricey private college, medical school, and then business school you might be able to support a pretty hefty sum. A state will not want to see its program misused as a tax shelter (its tax status as a 529 plan could be threatened) and if a state determines that you have made contributions without the intent to use the account for college it will terminate your account and perhaps assess an extra penalty.

Can I invest for one beneficiary in more than one state's 529 plan?
Sure, no problem. Most 529 savings plans have no state residency requirements. You can open accounts in as many of these states as you want, although in most cases there is little reason to have accounts in more than one or two states.

Why should I invest in a 529 plan when I can't be sure that my child will attend a public university in my state?
There's a misconception that state-sponsored 529 plans are only geared to families that send their children to a state school. That's just not true. There are two general types of 529 plans: prepaid programs and savings programs. The states offering prepaid tuition contracts covering in-state tuition will allow you to transfer the value of your contract to private and out-of-state schools (although you may not get full value depending on the particular state). If you decide to use a 529 savings program, the full value of your account can be used at any accredited college or university in the country (along with some foreign institutions). You can look up eligible institutions on the Education Department's school code search page.

Recent tax law changes now permit higher education institutions to offer their own 529 prepaid programs. These will allow you to target your tuition prepayment to the sponsoring institution (or group of institutions). The Independent 529 Plan is the only such program currently in operation.

How will a 529 plan affect my child's chances to qualify for financial aid?
Guidance from the U.S. Department of Education says that your 529 savings account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution toward your child's college costs will include 5.6 percent, or less, of the value of your account for each academic year. This is much better than the 35 percent assessment against assets owned in your child's name or in a custodial account.

Better yet, any distributions from a 529 savings plan this year should not impact a student's financial aid eligibility next year. According to the U.S. Department of Education, a tax-free 529 distribution does not have to be added back as "untaxed income." This position may change, so be careful.

Example: You file the FAFSA aid application when your child is a senior in high school. Let's say you have a 529 savings account with $20,000 in it, of which $10,000 represents your original contribution and $10,000 is earnings. Your eligibility for federal financial aid this year will decrease by no more than 5.64 percent of the account value, or $1,128. Assume there is no further appreciation in the account and you withdraw $5,000 in the fall to pay for the first semester college bills. If you have $15,000 left in the account when you apply for aid for sophomore year, you will again be assessed up to 5.64 percent, or $846, of the account value. The $5,000 withdrawal brought $2,500 of excluded earnings with it, but as indicated above, none of the withdrawal is counted as financial aid income. The federal aid formula is even more complicated than what is described here.

A 529 prepaid tuition plan works differently in the federal financial aid formula. Here your investment doesn't show up at all on the FAFSA. But the benefits paid out will be considered by the institution as a resource that reduces your child's overall financial "need." The bottom line effect for most families is a dollar-for-dollar offset in eligibility. That is, if your prepaid tuition contract pays out $5,000 in tuition benefits this year; you will be considered as having $5,000 less need for financial aid. Low income families that qualify for the Federal Pell grant will generally not be affected by a prepaid tuition plan (but they will be affected by a 529 savings plan).

Sound complicated? It is. And we are only talking about the federal financial aid rules here -- each school can (and most will) set its own rules when handing out its own need-based scholarships, and many schools are starting to adjust awards when they discover 529 accounts in the family. Also consider that the federal financial aid rules are subject to frequent change. Finally, remember that most financial aid comes in the form of loans, not grants, and so you end up paying it back anyway.

-- Posted: Aug. 11, 2005
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