So you’ve probably heard of the 529 College Savings Plan, but what exactly is it and how does it work?
That’s what we want to answer today. Surprisingly, 529 College Savings Plans have been available since 1996 with the Small Business Job Protection Act.
The 529 plans were then refined in 1997, 2001 and again in 2006 with the Pension Protection Act. 529 College Savings Plans have really become one of, if not the most popular way to save for college!
529 College Savings Plans got their name from Section 529 of the IRS code that allows for the special tax provisions related to these savings plans, which we’ll address.
What Exactly is a 529 College Savings Plan?
A 529 College Savings Plan is simply an account that allows you to save for college and has federal and (depending on the state) state tax advantages with regards to contributions and withdrawals for college.
Each state has its own 529 plan and has selected a company to administer their plans for them. For example, I live in Indiana where we have the Indiana College Choice 529 Plan through UPromise Investments.
There are actually two types of 529 plans - a college savings plans and a prepaid tuition plan. They share the same tax advantages, but there are some differences that we’ll reserve for a later post.
Today we’ll focus on the college savings plan portion.
How Does a 529 College Savings Plan Work?
A 529 College Savings Plan is simply an individual account that you save into where you pick a model or a target portfolio to invest into based on your age and risk tolerance.
Many plans have an “age-based” portfolio where the allocations are more aggressive in the child’s earlier years and as they get older the allocations switch to a more conservative mix.
There are also static portfolios where you can pick an allocation that doesn’t change over time.
These accounts are set up in the parents name with the child listed as beneficiary, so the parent retains the ownership and decision-making powers on the account.
When it’s time for college, the beneficiary can use the funds at any college in this country and abroad – as long as the school is accredited by the U.S. Department of Education.
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Advantages of a 529 College Savings Plan
529 College Savings Plans offer some pretty attractive advantages for those seeking to save for college – here’s a few:
- Tax-deferred growth - The money you contribute to a 529 plan grows tax deferred each year.
- Federal tax-free withdrawals – If the money is used for college, your withdrawals of contributions and earnings are not subject to federal income tax!
- State tax advantages – States may provide their own tax advantages to 529 plans. For example, Indiana allows for a 20% state tax credit up to $1,000 on contributions! Check your states rules on 529 College Savings Plans.
- Anyone can open and contribute - You don’t have to be a parent to open and contribute, which makes these plans very attractive for grandparents!
- High contribution limits - A lot of plans allow for very high contribution limits, sometimes upwards of $300,000 or more! In contrast, Coverdell Education IRAs allow for only $2,000 per year.
- Flexibility - You are not limited to choosing your own states plan, although you may not receive your state’s tax benefits.
- Simple and easy – You don’t have to worry about the investments too much since you choose model portfolios and 529 College Savings Plans are very easy to open – you can do it right online!
- You can switch beneficiaries – In other words, let’s say your oldest daughter decides she doesn’t want to go to college, you can remove her as beneficiary and add your son as beneficiary.
Disadvantages of a 529 College Savings Plan
Of course there is no such thing as a perfect savings plan, so here are some of the disadvantages:
- Investment options - You can pick portfolios, but not the underlying investment options.
- Investment inflexibility - Your plan may only allow you to change investment portfolios at certain times throughout the year.
- Consequences of not using money for college- Known as “nonqualified withdrawals”. You’ll have to pay a 10 percent federal penalty on the earnings part of any withdrawal that is not used for college expenses – depending on the state, there may be penalties from them as well. You will also pay income taxes on the earnings too!!
- Fees and expenses – Of course there are fees associated with 529 College Savings Plans. You may have annual maintenance fees, mutual fund expenses and the like.
