IF YOU'VE GOT college-bound kids, you've probably heard of section 529 plans. These tax-free vehicles are now widely viewed as one of the best ways — if not the best way — to save for college. But settling on the right college savings plan can be more confusing than that calculus course you took at your own alma mater. After all, more than 75 plans are available nationwide.
These plans have been around for a while. Michigan, Wyoming and Florida led the way in the mid-1980s, when they created these vehicles as an incentive for parents to save for in-state college education. The Internal Revenue Service balked initially, but Congress ruled in 1996 that the plans were legal and could be tax-deferred. Approval was granted in section 529 of the IRS tax code — hence the name.
But 529 plans didn't really take off until 2002, when, thanks to another change in the tax code, qualified withdrawals became tax-free rather than tax-deferred — a marked improvement. In addition, the plans themselves have become much more attractive: More plans have been launched with better investment options.
One big misperception still lingers — that they're limited to residents of the state running them, or that the beneficiary has to go to a school in that state. In fact, there are two distinct types of 529 plans: prepaid tuition plans and college savings plans. Prepaid plans do often carry residency requirements and typically are directed at paying for that particular state's university system — essentially paying tomorrow's tuition at today's prices. Just last year, however, a prepaid plan geared toward a large group of private schools was launched. Unfortunately, prepaid plans cover only tuition bills and, because of the way colleges view them when determining financial aid, can cut your aid packages dollar for dollar.
Savings plans, on the other hand, are more akin to 401(k)s for college — albeit with a few more restrictions: Your contributions are invested in a portfolio of mutual funds typically managed by an outside financial institution, such as Fidelity, Vanguard or T. Rowe Price. They generally don't have residency rules and can usually be used at almost any school in the U.S., and even some foreign schools. Gains are tax-free at the federal level as long as they're used to pay "qualified college expenses" (tuition, books, supplies, and room and board). Many states exempt earnings from state taxes for residents, too. And while these plans can also affect financial aid eligibility — they're not as restricting as prepaid tuition plans.
With a college savings plan, you can usually give as much as you want, since the contribution limits are quite high: often $200,000 to $250,000. Should you be lucky enough to have that much to contribute upfront, keep in mind that each individual (whether it's a parent, grandparent or someone else) can gift only $11,000 annually to any one person without cutting into their lifetime $1 million gift-tax exemption. In other words, if during your lifetime you gift more than $1 million (and this would only be $1 million in excess of the $11,000 you can give tax-free to each person you'd like every year), then you would be subject to the gift tax, which is taxed at the highest federal tax rate. One nice thing: 529 plans allow individuals to make five years' worth of $11,000 contributions upfront without triggering the gift tax. This means that you and your spouse could contribute $110,000 in one year without having to think at all about gift tax implications. And that ought to be enough to get junior's college stash growing quite nicely.
Even though there's a smorgasbord of state plans for parents to choose from, plenty of people may feel a natural tug toward their home state's plan. And assuming the plan has some decent investment options and low fees, that's not a bad idea, since many states (including Colorado and New Mexico) offer state-tax breaks for residents' contributions.
Keep in mind, we aren't saying 529s are perfect. Like IRAs, 529 plans can limit your flexibility: Should you want to withdraw your funds for something other than college-related expenses, you'll have to pay taxes plus at least a 10% penalty on earnings. But should junior decide to join a thrash band rather than head off to college, accounts can be transferred tax-free between family members, including cousins.
It's also important to note that there are good plans and bad plans. Some plans have very few options. The best plans offer age-based tracks (in other words, you're mostly invested in stocks while your child is young and gradually move toward fixed-income investments as he ages), as well as static portfolios (including all equity, all bonds or some mix of the two) and one money-market option.
One thing to keep an eye on is fees, which can vary widely by plan. You'll find everything from flat annual account fees to sliding scales. Some states are offering broker-sold plans, frequently with a more diverse menu of funds than the basic plan. But often the increased options don't make up for the added costs.
