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What are 529 Plans?

529 plans or qualified tuition plans are a form of tax-advantaged college savings plan. They are named after section 529 of the Internal Revenue Code.

529 plans are usually state-sponsored. However, universities and educational institutions may also form groups and sponsor their own 529 plans. The one who acquires the plan is called the donor, and the student that would use the saved funds or prepaid tuition credits is called the beneficiary.

529 plans may be sold directly by the state or the sponsoring group. However, they may also be obtained through brokers. In the case of the latter, you usually have to pay additional fees to cover the broker's commission (the sales load).

In-State 529 Plans versus Out-of-State 529 Plans

Consumers most often invest in 529 plans offered in their state. However, they may also invest in 529 plans offered in other states. Which is the better option: in-state 529 plans or out-of-state 529 plans?

Investing in in-state 529 plans comes with greater advantages than investing in out-of-state 529 plans. Some of the more important advantages are:

  • protection from creditors
  • scholarship and grant opportunities
  • state tax advantages

Advantages of a 529 Plan

The following are the benefits of using a 529 plan to save for college:

  1. Tax Benefits: The primary advantage of a 529 plan is the fact that your earnings made through the plan's underlying investments are not subject to federal tax (and more often than not, state tax). Furthermore, qualified withdrawals from 529 plans (withdrawals made for educational purposes) are also not subject to income taxes. Non-qualified withdrawals, however, are taxed the going income tax rate plus a 10% penalty on gains tax.
  2. Account Control: Another advantage of most 529 plans is the fact that they let donors maintain total control over their accounts. Most plans give donors the right to withdraw their investments any time they want.
  3. Ease and Flexibility of Saving for College: Compared to other investment vehicles, 529 plans are relatively simple instruments. Most plans have no age and income limitations. All one has to do is chose a 529 plan, sign up through the enrollment form and begin making paying for the plan, either through a lump sum investment or through periodic contributions. The money contributed is then handled by the plan itself or the state treasurer's office. Maximum amount per beneficiary can be substantial ($300,000/beneficiary).

    Donors can opt to switch between plans should they want to, provided that this does not violate any regulations in the 529 plan contract. They may also change their plan's underlying investments, again just as long as they do not violate the contract terms. Finally, some plans also permit account ownership transfers.

  4. Low Costs: The fees, the start up contributions and the monthly payments are generally low for 529 plans.
  5. Estate Planning Bonus: 529 plans are not considered part of the donor's gross estate by law. Thus, they are not included in estate tax computations. 529 plans, therefore, can be used as an estate planning tool should the donor want to move certain assets away from his estate while maintaining control over it. Of course a beneficiary must be named, in this case, and the 10% penalty tax and income tax still applies if funds accumulated through a 529 plan are not used to cover tuition and college-related expenses. In some cases though, a percentage of these taxes can be waived.

Disadvantages of 529 Plans

  1. Tax Penalties: Tax can either be a friend or enemy in 529 plans. It is a friend because money in a 529 plan grows tax-free. However, unqualified withdrawals or withdrawals made to cover non-educational expenses means income tax charges. As a general rule, income tax rates are greater than capital gains taxes, so you may end up paying higher taxes in the end.

    Unqualified withdrawals also trigger a 10% tax on gains. This further increases the tax penalties of unqualified withdrawals. Furthermore, few states treat 529 plan contributions as tax deductible expenses.

  2. Limited Investment Options: 529 plans have many disadvantages when used mainly as an investment instrument rather than a college-savings tool. For one, 529 plan holders cannot easily and readily switch among different investment options. Investment options may be changed only once a year. Investment options are also limited.
  3. Decreased Eligibility in Financial Aid Programs: 529 plans may decrease the eligibility of the college student (the beneficiary) to qualify for student financial aid programs. Assets in 529 plans are treated as parental assets and used in calculating a family's expected contributions to a student's college education. The greater the parents' or the family's expected contribution, the lower the financial aid to which the student is entitled.

Waiving 529 Plan Penalties

As above-mentioned, failure to use the plan on qualified educational expenses usually means a 10% early distribution penalty and income tax charges. These penalties are only waived if any of the following conditions are met:

  1. Additional College Support: If the beneficiary receives additional college support, the 529 plan can become unnecessary. Thus, it follows that the donor should be able to use the assets in the plan for non-educational purposes.

    An example of a situation where the waiver may apply is when the beneficiary receives a college scholarship, the proceeds of which are excluded from the calculation of gross income. Additional college support types that may void 529 plans include veteran's educational assistance and employer-provided educational assistance. Receipt of other non-taxable payments given specifically for educational purposes should also void applicable 529 plan penalties. Bequests, inheritances and gifts do not qualify as non-taxable types of payments in this case, however.

  2. Indefinite physical or mental disability: If the named 529 plan beneficiary is diagnosed to be physically or mentally unable to go to college and thus use the assets saved up in the plan for his college education, the penalties for making unqualified withdrawals from the 529 plan may be waived.
  3. Death of beneficiary. If the beneficiary of the 529 plan dies before he can use the plan's assets for his education, the penalty becomes moot and pointless. The 529 plan may be transferred, in this case, or the assets may be included in the estate of the deceased.
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