529 Plan

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DailyFinance  Apr 1  Comment 
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A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. 529 plans are sponsored by states or educational institutions and are authorized by Section 529 of the Internal Revenue Code, which created these types of savings plans in 1998. All fifty states and the District of Columbia sponsor at least one type of 529 plan, as do a group of private colleges and universities.[1]

There are two types of 529 plans: pre-paid tuition plans and college savings plans. If the proceeds from a 529 plan are used solely for education purposes, they will be exempt from federal taxes (and in most cases, state taxes as well). However, withdrawals for non-educational purposes will be subject to income tax and trigger an additional 10% federal tax penalty.[2]

One of the main disadvantages of 529 Plans offered by asset managers such as Fidelity is the inability of account holders to change asset allocation during the year. Most account asset allocation can only be updated once per year (versus daily and monthly for most 401(K) accounts). There has also been criticism of fees charged by asset managers due to this and other restrictions.

In 2000 a total of $2.6 billion was invested in 529 plans. This grew to $14 billion in 2001 and more than $92 billion in mid-2006. The student aid resource Finaid.org projects that total investment in 529 plans will reach $175 billion to $250 billion by 2010, with a total of 10 million to 15 million accounts opened.[3]

In 2008, many contributors to 529 Plans experienced significant drops in capital based on market value declines. The first half of 2009 is witnessing AUM growth especiallly in asset classes such as growth stocks.

Types of 529 Plans

When you enroll in a 529 plan, you will work either directly with a 529 Plan manager (see a list here), or through an investment manager. The company administering the account will control how the money is invested, and will charge an ongoing fee for its services. [4]

  • Savings Plans - these work like a 401k or Roth IRA, investing your money in mutual funds or other equity investments. Your account will go up, or down, in value based on the performance of the securities you choose to invest in. Most managers will provide options of which types of securities your portfolio will invest in.
  • Pre-paid Plans - these let let you lock in future tuition rates at in-state public colleges at current prices. They are usually guaranteed by the state. There is also a group of several hundred private colleges that offer a national prepaid tuition plan for private and independent colleges known as the Independent 529 Plan.[3]
Prepaid Tuition Plan College Savings Plan
Locks in tuition prices at eligible public and private colleges and universities.No lock on college costs.
All plans cover tuition and mandatory fees only. Some plans allow you to purchase a room & board option or use excess tuition credits for other qualified expenses.Covers all "qualified higher education expenses," including tuition, room & board, mandatory fees, books and computers (if required)
Most plans set lump sum and installment payments prior to purchase based on age of beneficiary and number of years of college tuition purchased.Many plans have contribution limits in excess of $200,000.
Many state plans guaranteed or backed by state.No state guarantee. Most investment options are subject to market risk. Your investment may make no profit or even decline in value.
Most plans have age/grade limit for beneficiary.No age limits. Open to adults and children.
Most state plans require either owner or beneficiary of plan to be a state resident.No residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers.
Most plans have limited enrollment period.Enrollment open all year.

Source: Smart Saving for College, FINRA® via SEC.gov

Benefits of 529 Plans

  • Federal Tax Benefits - Earnings in 529 plans are not subject to federal tax, as long as the withdrawals are used solely for education purposes.[1]
  • State Tax Benefits - Tax benefits for 529 plans vary by states, but in most cases the earnings are not subject to tax if they are used for education. Many states offer state income tax or other benefits, such as matching grants, for investing in a 529 plan. But you may only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence. Just a few states allow residents to deduct contributions to any 529 plan from state income tax returns.[1]
  • Control for the account holder - In a 529 plan, the named beneficiary has no rights to the funds. Instead, the donor/account holder decides when withdrawals are taken and for what purpose. Most plans even allow the donor to reclaim the funds at any time, although the earnings portion of the "non-qualified" withdrawal will be subject to income tax and an additional 10% penalty tax if it is used for purposes other than education. This level of control is especially significant when compared to a custodial account under the Uniform Transfers to Minors Acts (UTMA).[4]
  • Substantial deposits allowed - Everyone is eligible to take advantage of a 529 plan - there are generally no income limitations or age restrictions. Anyone can contribute money to a child's 529 plan - including relatives, friends, colleagues, acquaintances and even complete strangers.[3] Also, the amounts you can put in are substantial (over $300,000 per beneficiary in many state plans).[4] Federal law requires that 529 plans have safeguards to prevent contributions in excess of those needed for the education expenses of the beneficiary but does not otherwise limit contributions. Thus each state sets its own limit, with most states using an estimate of the amount of money that will be required to provide seven years of post-secondary education (including both undergraduate and graduate school). State contribution limits vary greatly, ranging from $146,000 to $305,000. The median limit is $235,000.[3]

Fees and Expenses of 529 Plans

The fees and expenses associated with 529 plans can lower your returns, and they vary based on the type of plan. Prepaid plans typically charge enrollment and administrative fees. College savings plans may charge enrollment fees, annual maintenance fees, and asset management fees, in addition to a fee paid to the brokerage. Some of these fees are collected by the state sponsor of the plan, and some are collected by the financial services firms that the state sponsor hires to manage its 529 program. Your asset management fees will depend on the investment option you choose. Each option usually carries a portfolio-weighted average of the fees and expenses of the mutual funds and other investments in which it invests. These are likely to be different for each investment option.[1]

If you invest in a broker-sold plan, you may pay your broker a commission for selling the college savings plan to you. Broker-sold plans also charge an annual distribution fee (similar to the “12b-1 fees” charged by some mutual funds) of between 0.25% and 1.00% of your investment.[1]

Many broker-sold 529 plans offer more than one class of shares, which impose different fees and expenses. Here are some key characteristics of the most common 529 plan share classes sold by brokers to their customers:[1]

  • Class A shares typically impose a front-end sales load. Front-end sales loads reduce the amount of the investment. For example, an investor has $1,000 and wants to invest in a college savings plan with a 5% front-end load. A $50 sales load is deducted from the $1,000, and the remaining $950 is invested in the college savings plan. Class A shares usually have a lower annual distribution fee and lower overall annual expenses than other 529 share classes. In addition, the front-end load may be reduced for investments above certain threshold amounts – this is known as a breakpoint discount. These discounts do not apply to investments in Class B or Class C shares.
  • Class B shares typically do not have a front-end sales load. Instead, they may charge a fee upon withdrawal of the money from an investment option, known as a deferred sales charge or “back-end load.” A common back-end load is the “contingent deferred sales charge” or “contingent deferred sales load” (also known as a “CDSC” or “CDSL”). The amount of this load will depend on how long the investment is held and typically decreases to zero if the investment is held long enough. Class B shares typically impose a higher annual distribution fee and higher overall annual expenses than Class A shares, but often convert automatically to Class A shares if held long enough.

If the beneficiary uses the money within a few years after purchasing Class B shares, the account holder will almost always pay a contingent deferred sales charge or load in addition to higher annual fees and expenses.

  • Class C shares might have an annual distribution fee, other annual expenses, and either a front- or back-end sales load. But the front- or back-end load for Class C shares tends to be lower than for Class A or Class B shares, respectively. Class C shares typically impose a higher annual distribution fee and higher overall annual expenses than Class A shares, but, unlike Class B shares, generally do not convert to another class over time. For long-term investors, Class C shares may be more expensive than investing in Class A or Class B shares.

References

  1. 1.0 1.1 1.2 1.3 1.4 1.5 sec.gov, "Introduction to 529 Plans"
  2. Investorwords.com, Section 529 Plan
  3. 3.0 3.1 3.2 3.3 Finaid.org, 529 Plans
  4. 4.0 4.1 4.2 savingforcollege.com, What is a 529 Plan?
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