Named for a section of the federal tax code, these plans are actually administered by states, and now attract the most savings for higher education.
You can invest after-tax dollars, up to the limit set by that state’s plan, and as long as the money is used for qualified college costs you won’t pay any more federal taxes on your investment or earnings. Qualified costs typically include tuition and mandatory fees; books, computers, and other required supplies; and room and board if the student attends at least half-time. Qualifying schools include any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education, and offering credit toward an associate’s, bachelor’s, graduate-level or professional degree, or another recognized post-secondary credential.
What if your child decides not to use the money toward a college education? A 529 allows you to change the beneficiary to another family member. If you decide to simply withdraw the money, you will have to pay a 10 percent penalty as well as state and federal taxes on the account’s earnings—though not on contribution amounts.
You don’t have to invest in your own state’s plan, although that’s where you should look first, because many states provide tax deductions for in-state investors. (Go to www.finaid.org to see whether your state is among them.) The plans generally offer a few investment options, but it varies from state to state. One of the best websites on 529 plans is www.savingforcollege.com, which is owned by Bankrate.com and offers news and information on all state programs. You can also find general information and links to your state's program, as well as comparing your state’s plan with competing ones, at www.collegesavings.org.
When assessing different 529 plans, compare these features.
Extra fees and expenses. State 529 plans vary widely in their investment options and their investments are subject to expenses and fees (such as application and maintenance fees) that can vary dramatically and take a good bite out of your college savings. Fees for 529 plans can go up as high as 1.5 percent each year of the money you’ve invested. Ideally, “You want the plan that has fees under 1%,” says Mark Kantrowitz.
The most economical way to sign up is to invest directly and avoid the commissions, which you might incur by going through a financial adviser. There’s also the risk that an adviser may steer you to an inappropriate out-of-state plan simply because he or she stands to earn a higher commission. When comparing state agencies and investment advisers, “the fees will be much higher with investment advisers, who are influenced by commissions,” says Kantrowitz. Check state plan websites directly, he suggests, where you can set up a plan, as well as find phone numbers and forms to print out and mail in. You can find state 529 websites through www.collegesavings.org and www.savingforcollege.com.
Investment options. These plans vary widely. Some 529s offer a choice of individual mutual funds or age-based plans that are structured somewhat like target-date retirement funds—they invest more aggressively when the beneficiary (the student) is young and adjust the portfolio's asset allocation to more conservative investments as he or she gets close to college age. The major difference is that with a 529 plan, you're saving for about 18 or 20 years and spending all of it in four years or so.
The sooner you need to get your money out, the more conservatively you should usually invest it. With a new baby, you can probably afford to take some chances, but when your child reaches high-school age, you may want to shift at least gradually into one of the less-risky options. You can also diversify your 529 by spreading your money among several types of investments. Learn more here.
Most successful long-term investment plans should be based on the familiar structure of stocks, bonds, and cash; over a 15- or 20-year span, returns on more conservative bank certificates of deposit will almost certainly fall short. Learn more here.
The value of tax deductions
Skewing conservative can present an obvious problem: how to keep up with the annual inflation rate of college costs—anywhere from 3 to 9 percent, depending on the type of school. Expectations for stock returns have been lowered recently to about 7 percent a year in average long-term performance. Fortunately, some plans have sliced expenses, which will help overall performance.
Favorable tax treatment provides a boost. For example, New York allows individuals to deduct contributions to in-state 529 plans of up to $5,000 ($10,000 for married couples filing jointly) on state income-tax returns. In Illinois, individuals can deduct $10,000 a year ($20,000 for joint filers). Then again, some states don't have state income taxes to begin with.
Depending on where you live and the plan you choose, that tax benefit might make up for some drags in plan performance. To test this theory, we analyzed how a 529 investment might do for a couple earning $100,000 in five higher-taxed states' plans vs. an out-of-state plan that doesn't allow you to deduct contributions on your state income tax. An out-of-state plan that earned one percentage point more than an in-state plan would be more advantageous in four of the five states we analyzed.
Other ways to save on your taxes while saving for college can be found at the IRS’s Tax Benefits for Education and the American Opportunity Tax Credit pages.