Homework Will Help You Pick the Proper 529 Education Savings Plan

With higher education costs rising at an average of 1½ to 2 times the general inflation rate, saving for future college expenses is paramount. Tax-advantaged 529 savings plans can be very effective tools to help save specifically for college funding.

Every state offers a 529 plan, providing many plans to choose from. Here are some considerations when opening a 529 plan.

Taxation

These education savings plans, named after Section 529 of the Internal Revenue Code that authorizes them, offer savers very attractive tax benefits.

Once contributions are made, investments within a 529 grow on a tax-deferred basis. More importantly, distributions to pay for eligible college costs, such as tuition or room and board, are federally tax-free. This favorable tax-treatment is significant, particularly for long-term savers who have had substantial growth within their account.

However, keep in mind that tax-free treatment only applies to withdrawals made for qualified school expenses. Distributions that aren't used for education are both federally taxable and hit with a 10 percent penalty. So be careful not to significantly overfund a 529 above anticipated college costs.

In addition to federal benefits, there can also be state-specific breaks. For instance, states with an income tax typically offer residents who participate in their state-specific plan a deduction for contributions or income exemptions for withdrawals on their state tax returns.

Start with research into what benefits your particular state plan offers. If you don’t get any benefits from your state, explore plans offered elsewhere. There are no residency requirements or limitations on school selection based on where an individual’s 529 is located.

Fees

Almost all plans will charge an annual maintenance and asset management fee. Some also may require an enrollment fee. While these fees are necessary to fund the support required for the plan, it is important to have a good understanding of a plan’s expenses to ensure they are reasonable.

Individuals who invest in 529 plans through a broker or bank, for example, typically are subject to numerous additional fees when compared to the average state-provided plans. This is primarily due to up-front sales loads charged by the broker as a commission for selling the 529.

Other fees to look out for include annual distribution fees, service fees and high loads on underlying investments. To avoid these, check into direct-sold plans rather than their broker-sold counterparts.

Investment Options

Most plans offer pre-defined asset allocations composed of a mix of underlying mutual funds based on an established goal of the portfolio. A common strategy is an age-based portfolio. These invest more aggressively in the beneficiary's younger years and automatically become more conservative as the student nears college attendance.

Plans vary greatly on the number of options, with some having as little as three portfolios and others as many as 12. On the high end of the scale, the Utah Educational Savings Plan has proven very attractive. It has a dozen different pre-defined portfolio options, as well as customized options that enable you to tailor an asset mix particular to your individual needs.

Reviewing a plan’s fund offerings, as well as the fees associated with them, is essential to determine whether the plan offers an option suitable for you.

Financial Aid

Ownership of the 529 is particularly noteworthy when it comes to financial aid considerations.

Most plans are opened in a parent’s name for the benefit of the child. This can be advantageous when applying for federal student aid. While the 529 will be includable as a parental asset when completing the Free Application for Federal Student Aid (FAFSA), it will reduce aid eligibility at a lower rate than if the savings were titled directly in the name of the student.

Many families, however, are under the false impression that 529 accounts are not includable on the FAFSA as long as they are titled in a name other than the student or parent. This is true from an asset standpoint, but there are caveats.

For example, while a grandparent-owned 529 would not be included on a student’s first year application for aid, the reverse occurs once withdrawals begin. As the student receives money from the non-parent owned plan, it becomes untaxed income to the student that is now includable on subsequent year’s FAFSA. Since income included on the FAFSA is calculated at a higher rate than assets, this could result in significant aid reduction in later years.

Divorce situations are equally complex. Since only the custodial parent’s income and assets are reportable on the FAFSA, the non-custodial parent is then considered the same as any other relative or owner. This means withdrawals from a 529 owned by the non-custodial parent would be includable as income just as if it were held by a non-parent.

Effective strategies in divorce situations include keeping the 529 plans titled in the custodial parent’s name or waiting to spend non-parent-owned assets until the student’s last year of school.

Although 529 plans are not the only option for education savings, they can be effective tools to help ensure these needs are met appropriately and efficiently. Doing your homework when it comes to 529s will ensure your savings strategy meets your student's funding needs. Your financial advisor can help you determine what tools are best for your particular situation.