To encourage families to start
saving early for college, all states now sponsor what are commonly called 529
plans. Named after the section of the federal tax code that allows them, they
offer significant tax benefits.
There are two basic types of 529 plans: savings
plans and prepaid
tuition plans. The more popular is the savings plan.
With a 529 savings plan, parents open an account and
choose an investment strategy. Earnings accumulate tax free and
withdrawals can be made tax free, when it's time to pay for a child's
college expenses including tuition, books, and room and board.
How it works
Money from a state-sponsored college savings plan can be used to
pay for educational expenses at any accredited college or university.
Each savings program offers parents several different
investment choices. Because many state programs are open to nonresidents,
it makes sense for parents to shop around for a plan that best meets
their financial and educational needs.
A popular type of college savings plan begins
with some aggressive investments and grows more conservative as
the potential college student grows up.
Many plans allow anyone -- from any state -- to contribute to a
529 plan. If you start a 529 account for your child in your home
state, grandparents or even friends can contribute to it, even if
they live across the country.
For example, if you start a 529 plan in Minnesota, relatives or
friends who live in Oregon can still contribute. The caveat is that
some states may charge residents a tax on earnings on out-of-state
So you've planned ahead for your child's education. What happens
if a potential college student decides not to go to college?
|A parent has three basic choices:
||Hang on to the savings plan
||Transfer it to another family member
||Cash out and pay a penalty
Some parents hang on to the 529 plan in case the child
decides to attend university at a later date. Others transfer the
account over to another family member.
Some parents decide to cash out the plan and pay a
penalty. Most states collect a penalty of 10 percent of the earnings
on any withdrawal that is used for non-educational purposes.
A federal penalty equal to 10 percent of earnings
will be charged as well. No penalty will be assessed if a beneficiary
should die or become disabled.
While the tax-free withdrawals clearly make 529 plans
attractive financial options, they may not be right for every family.
The reason? Participating in a 529 plan affects a family's eligibility
for financial aid.
Who can benefit?
Some financial advisers urge lower-income families, who are likely
to receive a large amount of financial aid, to pass on 529 plans.
If you're likely to qualify for financial aid, the existence of
a 529 savings plan may reduce or eliminate the amount of aid you
can receive. That's because for financial-aid purposes, savings
plans are considered an asset of the account owner.
If the parents hold the plan, the amount of financial
aid the student may be eligible for will be reduced by up to 5.6
percent of the savings account. A family with $40,000 in a 529 savings
plan, for example, would see their financial aid decrease by as
much as $2,240.
College savings plans may make the most sense for
upper-income families who won't qualify for financial aid and for
middle-income families who qualify for loans and little else.
While a state-sponsored plan has benefits, the costs may be higher
than you think. Invest in a high-priced plan and you'll lose a nice
chunk of earnings to hefty management expenses and other fees.
Let's say your family contributes $600 a year to a
college savings plan with a $50 annual maintenance fee. And let's
suppose an 8 percent return. By year's end the account balance would
swell to $648. But that $50 maintenance fee would knock it back
down to $598. So after a year of investing, you've got $2 less than
when you started.
A key advantage of a 529 plan -- tax-free earnings
-- matters little if fees eat up all or most of your earnings.
The good news is many college savings plans will waive
annual maintenance fees to in-state residents, people who make automatic
contributions and people with large account balances, often $25,000
The bad news? There are plenty of other fees to worry
about. Several college savings plans charge you a one-time enrollment
fees right from the get-go. These fees range from $10 to $90, and
most are under $50.