What Is A 529 plan?
Simply put, 529 plans are tax-advantaged college investment plans authorized by Section 529 of the Internal Revenue Code - and so the name. The IRS officially calls these plans qualified tuition plans or QTPs. But this simple description disguises the true significance of the investment.
529 plans are incredibly valuable tools designed to encourage American citizens to invest for their and their family members' future college expenses by allowing the putting away of money into state sponsored accounts. If done wisely, the investment proceeds withdrawn for higher education expenses are totally exempt from state and federal taxes!
The History Of The 529 Plan
The federal law which created the plan in 1996, and eventually the generous federal tax advantages, originally had nothing to do with saving for higher education. Congress created section 529 plans in provisions that were part of the Small Business Job Protection Act. It improved the law the following year in the Taxpayer Relief Act. It, again, made improvements to section 529 with provisions in the Economic Growth and Tax Relief Reconciliation Act in 2001.
In 2006, in the Pension Protection Act, Congress put many minds to rest by making the federal income tax exclusion for higher education withdrawals from 529 plans permanent, finally setting into stone one of the most important benefits of the plan. Congress also continued the exclusion from state income tax all qualified withdrawals.
More 529 benefits have also been continued, including the allowing of same-beneficiary rollovers.
The list of people who are considered members of a family for the purposes of section 529 rules already included the members and stepmembers of an extended nuclear family, but now they include first cousins.
The Mechanics
As state sponsored programs, 529 plans are now available in all fifty states. Anyone can contribute to a plan, regardless of their income, and you can usually opt for automatic monthly contributions from your bank with minimum amounts as low as $25. You can research what your and other states offer by looking through their official web portals and following the education links.
When you open an account for yourself or on behalf of a family member, you are actually doing so with the investment company that administers the plan according to the investment guidelines set up by the state. Your money is invested in a diversified portfolio and you deal directly with the investment company. It's similar to the experience of dealing with the company which handles your Roth IRA, so you cannot deduct contributions from your federal income tax. Plus, like your Roth, there are important ongoing administration fees which vary by state and must be seriously looked at, and there is usually a 10% federal early withdrawal penalty.
More About Tax Benefits
In addition to making withdrawals tax exempt for residents contributing to their state's 529 plans, each state has a wide latitude in determining the tax deductibility of annual 529 plan contributions.
For example, Arizona, New York, Florida and California residents pay no federal or state taxes on their qualified withdrawals, but Arizona, under its "Arizona Family College Savings Program" and New York, under its "Direct Plan" now allow annual state tax deductions of $5,000 per individual for contributions equaling or exceeding this amount. The deduction doubles for married couples. Florida, under its "Florida College Investment Plan" and California, under its "ScholarShare College Savings Plan" have special calculations to perform in order to determine how much of their contributions are deductible.
On the high end of deductibility, Illinois, Mississippi and Oklahoma plans allow for a married couple to deduct up to $20,000 a year for contributions. On the low end, Nebraska and Rhode Island allow for a maximum deduction of only $1,000.
Do Your Homework, Do The Math
When choosing to contribute to a state's 529 plan, you'll want to very carefully weigh the pros and cons of instate and out-of-state plans and state tax deductibility, as well as the maximum contributions allowed and the respective front end and back end fees the investment companies charge. These fees can significantly cut into the earnings from 529 investments.
In an August 23, 2002 article by Austan Goolsby entitled The "529" Rip-Off : Those New College Savings Plans Aren't So Great, long-term concerns are raised regarding the fees attached to many of the plans:
"... serious flaws in the 529s are being overlooked. The long-run potential of the plans has been seriously compromised by excessive "management" fees that states have added to these plans. In addition, all but a few of the plans limit investors to a single financial firm that offers only two or three investment options. The reality of 529 plans is that much of the tax subsidy is merely going to pay these higher fees to states and financial companies. Under some plans, families would actually do worse investing in 529 plans than in traditional savings instruments."
So, it would behoove the smart investor to pay special attention to any particular plan's fee structure.
