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What you need to know about 529 college savings plans

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What you must know about 529 plans
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What you must know about 529 plans | Blend Images - KidStock/Getty Images

What you must know about 529 plans

The college savings plans known by that weirdly random number "529" are hugely popular, and with good reason. A 529 plan:

  • Offers federal and, in some cases, state tax advantages.
  • Has low maintenance costs.
  • Provides tax-deferred growth.
  • Has less of an impact on a student's financial aid package than money stored in checking and savings accounts.

The savings plans – named after the section of the tax code that authorized them – can be complex, and choosing the one that fits your family can be daunting. Know these seven points before opening a 529.

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Some are pricier than others | Matthias Tunger/Getty Images

Some are pricier than others

College plans come in two flavors:

  • Prepaid plans that allow families to buy "units" of tuition at a rate close to today's prices. They are cashed in when the student attends school.
  • 529 college savings plans that allow families to invest in preselected investment portfolios that grow (or shrink) in sync with the markets.

Many states and the District of Columbia offer 529 college savings plans. But only a handful of states offer a prepaid option.

Both types of plans come with annual fees and operating costs. The expenses can nibble away up to 2 percent of invested assets, depending on the types of investments and the fund company.

One of the main factors that can drive up costs is if a 529 plan is broker-sold and overseen by a financial professional. The alternative is direct-sold, in which plan holders control their own assets.

"The broker-sold adviser plans ― there's a higher expense structure to those plans, but what you do get for those higher costs is the advice of the financial professionals you're working with," says Paul Paeglis, who used to oversee Ohio's 529 plan.


There's risk involved | Hero Images/Getty Images

There's risk involved

Many 529 college savings plans hold mutual funds that are tied to the stock and bond markets, meaning families can potentially lose money if the investments falter.

"The question you have to ask yourself is: 'How diversified is the 529 itself?'" says Sam Mikhail, founder of College Made Easy, a college planning firm in the Los Angeles area.

When deciding on a college savings plan, Mikhail advises families to take a look at the underlying funds and investigate the historical performance of each. There are generally multiple investment options to choose from in 529 plans.

Families also may also want to consider the growing number of no-risk 529 plan options. Several states offer certificates of deposit insured by FDIC and other savings options that provide families with 529 tax benefits without the risk (or growth) associated with market fluctuations.


They might not keep up with your kid | Hero Images/Getty Images

They might not keep up with your kid

Some of the more popular 529 college savings are age-based, target-date funds that automatically shift from aggressive to conservative investments as your kid approaches college age.

Stuart Ritter, former vice president of T. Rowe Price Investment Services and now an executive at PNC, advises that families choose age-based portfolios carefully.

"It's important to understand what the investments are, and make sure that how your money is allocated between stocks, bonds and short-term investments is appropriate for the time horizon you're looking at," Ritter says.

How frequently investments change varies among 529 plans. If a plan isn't changing according to your needs, the IRS allows you to swap out portfolios once per year.


Your state may not offer the best plan | Blend Images - KidStock/Getty Imagess

Your state may not offer the best plan

While all 529 plans come with federal tax advantages, certain states also offer state income tax deductions or credits, too. These can be significant.

For example, Indiana offers a tax credit of up to $1,000 per year. New York provides an annual tax deduction of up to $5,000 for 529 contributions, and Oklahoma has an up to $10,000 deduction.

Those are for single filers; the limits double for married couples filing jointly.

A few states have matching grant programs that double a certain amount of a family's contributions.

While these incentives can provide an extra push to invest in your home state's plan, your family still should look at out-of-state 529 plans, says Deborah Goodkin, managing director of college savings plans at First National Bank of Omaha, which oversees Nebraska's 529s.

"If (a 529 plan offers) tax advantages, it may or may not be the best reason to invest in your home state's plan," she says.

You also need to take a close look at fees, which can make a sizable dent on investment returns.


Most prepaid plans aren't guaranteed | Hero Images/Getty Images

Most prepaid plans aren't guaranteed

Prepaid 529 plans ― also known as prepaid tuition plans ― aren't subject to market ups and downs, but they're not always a sure thing either.

"There are not a lot of states that even offer prepaid plans anymore, and the level of guarantee amongst those states definitely varies," Paeglis says.

Among prepaid 529s, only a scant few, such as Washington's Guaranteed Education Tuition program, come with a legally binding promise the state will pay if the plan folds between the time parents open the account and the kid goes off to school.

Families considering a prepaid plan should:

  • Inquire about a state-backed guarantee before opening the account.
  • Research the plan's historic performance and stability.
  • Ask what happens if tuitions increase sharply.

529s impact financial aid | Hero Images/Getty Images

529s impact financial aid

It's true that funds in 529 plans will factor into how much financial aid a student may qualify for, but it shouldn't be an obstacle.

"People think if I have $100 saved in a 529 plan, that means I'm getting $100 less in financial aid. That is wrong," says Ritter.

Money saved in a 529 will affect your federal financial aid package, but not as much as funds stored in some other types of accounts.

Every dollar stored in a 529 account in a parent's name will subtract up to 5.6 percent from your family's federal need-based financial aid package, according to the U.S. Department of Education.

By contrast, funds stored in checking and savings accounts in a child's name will subtract up to 20 cents per dollar of federal financial aid.

Funds invested in an individual retirement account (IRA) in either a parent's or child's name won't be considered at all until the family begins taking withdrawals. At that time, those funds would be considered untaxed income and could make a severe impact on financial aid.


Relatives can help (and also hurt) | Hero Images/Getty Images

Relatives can help (and also hurt)

One way to get around the federal financial aid assessment is to put 529 cash in an account held in a relative's name. That would shelter the money from the federal financial aid needs analysis.

What's a needs analysis? It's the primary formula used to figure financial aid at public colleges and universities. Note that those funds would still be factored in for students attending many private colleges.

Even if the money is sheltered, that's only temporary. According to the Department of Education, once students begin taking withdrawals from 529 accounts held in relatives' names, the money counts as income and can subtract up to 50 cents in federal aid for every dollar withdrawn.

To get maximum federal aid and minimal 529 impact, families can postpone taking 529 withdrawals from relatives until after the student has received financial aid for the final year of school.

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