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What Is a 529 Plan? How Can It Help You?

Posted by Francesca Fulciniti | Jul 1, 2016 9:00:00 PM

Financial Aid

 

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If you want to save in a smart way for college (either for yourself or your child), you’ll want to make the most of your money. One of the best savings plans meant specifically for growing a college fund is called a 529 plan, or a qualified tuition plan.

But what is a 529 plan? Like any sort of investment plan, there are several types of 529s, all with their own benefits and drawbacks. In this post, I’ll talk about the basics of 529 plans, why they’re helpful, whether they affect financial aid, and where you can get one.


What Is a 529 Plan?

According to the IRS, a 529 plan is an investment savings plan with tax incentives (and sometimes other benefits) to make it easier to save for post-secondary education. It’s an account in which you contribute a portion of your income to save for future college expenses. They’re generally run by state governments or education institutions, not banks.

A 529 is typically a “set and forget” sort of savings plan (although you have a few different options that I’ll get to shortly) - you decide to make whatever contributions you’d like and a fund manager makes investment choices for you. Some plans require you to purchase “packages” to cover future tuition costs, whereas others allow to contribute however much you want, however often you want.

One of the things that makes it special is that it can only be used for education expenses in the future, and can be opened by anyone (the saver) for anyone (the beneficiary).

The main advantage to having a 529 plan is that earnings (i.e. the money that the plan makes while your money is invested) are not subject to federal tax, and are generally not subject to state tax, when used for educational expenses. Eligible expenses usually include things like tuition, fees, books, room, and board.

In sum:

  • You contribute some amount of your post-tax income either on a regular or more flexible schedule.
  • The money you contribute to the plan is invested, and will usually grow (or will be guaranteed to be worth a certain amount in the future).  
  • When the plan’s beneficiary wants to use the money for eligible educational expenses, the money can be withdrawn and you don’t have to pay taxes on any money that your plan makes (e.g. capital gains taxes).

 

I’m Still Confused - Why Is a 529 Plan a Good Thing?

529 plans are similar to retirement savings plans in a few different ways. Because people are generally more familiar with the way retirement savings plans work, I’ll use them as an analogy.

Just like with 529 plans, there are a few different retirement savings options (e.g. traditional IRA, Roth IRA, 401k), but the bottom line is that they’re all options with tax benefits and incentives to help you save. Depending on what plan you decide to go with, you may have more or less flexibility and/or opportunities for capital gains.

As with retirement plans, time is your friend when it comes to 529s - more time means you can contribute more money to the plan, and your money has more time to grow on its own as an investment. You could just stash money away in a savings account, but you’ll probably see less growth due to low interest rates, and you’ll have to pay taxes on any earnings.

Just like with any other investment, there is some risk involved in putting your money in some types of 529 plans (I’ll talk more about this shortly). You may not gain as much money as you anticipate, for example. Overall, though, 529 plans are pretty conservative and provide respectable earnings. Once again, time is your friend!

 

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This holds true for any investment or savings plan, really - if you give your money more time to earn, you’ll generally be happier with the outcome.



Types of 529 Plans

There are two main types of 529 plans: prepaid tuition plans and college savings plans. I’ll talk about both of these plans here.

 

Prepaid Plans

Prepaid plans are primarily sponsored by states. Investments are “guaranteed,” which means that your money is certain to be worth a certain amount in terms of tuition (and sometimes room and board) dollars when the beneficiary heads off to college. Ultimately, these plans “lock in” a certain rate of tuition.

Savers purchase “units” or “credits” at participating schools (usually public, in-state schools) for future education expenses for a beneficiary. You usually have the option to choose from several available packages that lump units together (e.g. one year of tuition, two years of tuition, tuition plus housing, etc). It’s typical to have the option to pay with a lump sum or with monthly installments. The older the beneficiary is when you start purchasing credits, the more expensive these units become.

These plans often have residency requirements, which means you have to live in the state that sponsors that particular plan. You should be able to transfer the value to private and out-of-state schools, but you may not get the full value of your plan (this varies widely by state).

Ultimately, prepaid plans are fairly “safe” because of the guaranteed nature of the investment (although some argue that the deal isn’t as great as it’s made out to be). They are fairly inflexible, however - if the beneficiary chooses to attend a private or out-of-state school, you probably won’t be able to transfer the full value of the plan.

Here’s an example of a prepaid plan in action:

Let’s say you’re interested in the Florida state 529 prepaid plan for your newborn. There are different packages available, but you choose to buy the four-Year Florida University tuition package. This would cost you $28,888.39 in 2016. In 18 years when your newborn heads off to college, the money you spent in 2016 would cover all tuition expenses at an FL state university, no matter how high the costs are in 2038.



College Savings Plans

College savings plans are a bit easier to understand than prepaid plans. Simply, a college saver opens an account for a beneficiary (the student) to pay for the student’s eligible college expenses (room, board, tuition, fees). Tax-advantaged college savings plans are usually run by states themselves - some banks offer these plans, but they won’t come with the same advantages that you can get through your state plan.

There are often many investment options to choose from, so the saver can freely customize his/her investment. Withdrawals from this type of plan can usually be used at any college or university, which offers a lot more flexibility for the beneficiary when it’s time to head off to college.

Your rate of return on your investments will depend on your specific choice of plan, but some college savings plans may earn as much as 3 to 3.5%. The downside to college savings plans is that unlike prepaid plans, your investment is not guaranteed - they’re subject to market fluctuations, just like any other investment. The upside to these plans is the degree of flexibility they offer, both in the beneficiary’s choice of college and the amount the saver chooses to contribute.


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College savings plans are sort of like this gymnast - they’re flexible but also not afraid of a little risk.

 

Here’s an example of a college savings plan in action:

Let’s say you’re interested in a college savings plan for your 8-year-old. You’re not sure where he’ll want to go to school, so you prefer a college savings plan to a prepaid plan because it’s the more flexible option.

Your son will be ready to head off to school in 10 years, so you start contributing $5,000 annually to the 529 plan of your choice. Your money is invested in a mutual fund, so you know a certain rate of return is not guaranteed. Your investment does well, however, and you see an annual rate of return at 3.5%.

After 10 years you will have contributed $50,000 to the plan, but your ending balance will be $60,710 - you won’t have to pay any taxes on these gains. If you’d put away the same amount into a savings account with an interest rate of 3.5% over 10 years, your ending balance would come to $57,818 (assuming an annual tax rate of 25% on capital gains).



Overview: The Main Differences Between Prepaid and College Savings Plans

 

Prepaid Tuition Plan

College Savings Plan

Tuition Price Lock

Locks in tuition prices at certain schools

No lock on tuition costs

Eligible Education-Related Expenses

Generally just for tuition and mandatory fees

For all college-related expenses, including tuition, room, board, fees, books, computer

Investment Guarantee

State plans are guaranteed or backed by the state

No state guarantee; your investment is subject to risk just like any other investment (money could fail to grow, or you could even lose money)

Age Limits

Most plans have an age limit for the beneficiary (student)

No age limits; open to adults and children

Residency Requirements

Most state plans require either the owner (saver) or beneficiary (student) to be a resident of that state

No residency requirement, but there may be some limitations in how you can purchase the plan

Enrollment Periods

Most plans have limited enrollment periods (periods when you can start participating in the plans)

Open enrollment; you can start participating whenever you’d like



Should You Get a Prepaid or a College Savings Plan?

Your choice of 529 plan will depend on a few different factors.

First, how much flexibility in school choice are you looking for? Prepaid plans are less flexible, and as such are best for in-state public schools. You should be able to transfer credit from a prepaid plan to out-of-state and/or private schools, but you probably won’t get the full value of the plan. The actual amount that you’d be able to transfer depends on the individual plan.

  • Bottom line: If flexibility is a priority, college savings plans may be the better option. If you’re confident that your child will attend an in-state public school, prepaid plans may be the best fit.

Second, what’s your preferred level of risk? Prepaid plans are generally sponsored by the state - the investments, credits, units or whatever you purchase tend to be guaranteed by the state with these plans. College savings plans, on the other hand, don’t generally guarantee returns (unless, of course, they’re sponsored by the state).  If the market performs very well your money could do better than you expected in a college savings plan, although the opposite is also true.

  • Bottom line: If you’re particularly risk-averse, you may prefer a prepaid plan. If you value flexibility over the relative safety of a conservative investment, you might be happiest with a college savings plan.

 

Will a 529 Plan Decrease Financial Aid Eligibility?

You might worry that having an investment account earmarked for college expenses might decrease student aid eligibility. In reality, a 529 savings plan has little effect on how much money a student will receive in financial aid.

529 plans are considered parental assets. As such, they’re factored into federal financial aid formulas at a max rate of 5.6% - that means that 5.6% of your 529 savings are included in the “expected family contribution,” the figure that’s so important in the calculation of financial aid. Ultimately,  family income is considered a much more important factor when it comes to determining aid eligibility.

Learn more about calculating your financial aid eligibility.



Where Can You Get a 529 Plan?  

Each state has its own sponsored 529 plans, but enrollment is sometimes limited based on the type of plan and your own (and/or the student’s) state of residency. You may be able to enroll directly in the plan, but in other cases you’ll have to enroll via a financial broker.

To get information on state-specific plans, Google “[state] 529 plans.” Any page that talks about a state-sponsored plan will have more information about plan details and how to enroll.


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There are a lot of ads that come up with 529 plan searches, but the first non-ad result is your best bet, like in this example.



Summary

Hopefully you have a better idea of what 529 plans are and how they can be useful. There are a lot of different options depending on your savings goals, state of residency, and flexibility needs. I encourage you to look at your own state 529 options to see if particular plans appeal to you.

If it’s an option, I also encourage you to talk to an expert or trusted financial advisor for advice and guidance!  

 

What’s Next?

If you’re thinking about saving for college (for either yourself or a beneficiary), pat yourself on the back for being so proactive and forward-thinking. Something else you can do to prepare for the future is learn more about college expenses and how to minimize them.

First, check out our complete guide to college costs - this outlines all the obvious and hidden expenses associated with going to college. If you’re surprised by how expensive college really is, you may want to read up on why college costs so much.

Don’t get discouraged by these sticker prices, though! To figure out how to tackle these costs, check out our complete guide on how to pay for college (it may not be as daunting as you think).

 

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Francesca Fulciniti
About the Author

Francesca graduated magna cum laude from Harvard and scored in the 99th percentile on the SATs. She's worked with many students on SAT prep and college counseling, and loves helping students capitalize on their strengths.



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