Daniel Lee, a summer intern at Old Peak, was the lead researcher and author of this paper. Daniel double-majors in finance and economics at Penn State.

What is a 529 college savings plan?

A 529 plan is a college account savings plan exempt from federal taxes. The government introduced these plans to help taxpayers save money for college.

529 plans are also known as “qualified tuition plans”(1). They are typically sponsored by a state. 529 refers to the section of the Internal Revenue Code that describes the plan’s tax advantages.

There are two different types of 529 plans: pre-paid tuition plans and college savings plans. All 50 states and the District of Columbia sponsor at least one type.

College savings plans vs. pre-paid tuition plans

College savings plans are the more popular type of 529. They allow a saver to create an account for a student. When the student attends college, the money pays for eligible expenses(1). A 529 account is similar to any other type of investment account. You invest the money, usually in a mix of mutual funds owning stocks and bonds. You expect the money to grow over time. When the beneficiary goes to college, you use the money to pay for expenses like tuition, room and board.

By contrast, a pre-paid tuition plan allows people to purchase units or credits at participating colleges and universities. These units pay for future tuition and, in some cases, room and board(1). A benefit: you avoid the risk that college inflation will exceed the return you earn investing your 529 dollars. But prepaid tuition plans have decreased in popularity in recent years. A key reason: you must commit up-front to attending a public university in-state.

Who can open an account?

Any U.S. citizen or resident alien 18 years or older can open a 529 account. Typically, an adult will open an account for another beneficiary, such as a child or grandchild. Adults can also open a 529 plan to save money to pay for their own higher education costs since there are no age limits for the beneficiary. (2)

What are the benefits?

• No income tax on investment gains. Earnings from the plan grow tax-deferred. Earnings are never taxed if the money is used to pay for college. (3)
• Additional state tax savings. Your state of residency may offer additional tax breaks. 34 states, including the District of Columbia, offer residents a full or partial tax deduction or credit for 529 plan contributions. (3)
• Control for the donor. The beneficiary can only use the funds for the intended purposes. As the account owner, you can also withdraw funds from the account for any reason, although you may face a tax penalty for non-qualified withdrawals. (3)
• Automated investing options. Most 529 plans offer “age-based” investment options that make all the investing decisions. An age-based plan uses a mix of stock and bond funds depending on the beneficiary’s age. The mix adjusts to be more conservative as the student nears college. That avoids the risk of a large stock market decline just before the money is withdrawn.
• Low fees on many plans. Many plans offer low fees. These are typically “retail” plans – plans you set up directly, on-line, without an advisor’s help. By contrast, advisor-connected plans are usually very expensive.

What are the disadvantages?

• Penalties if money is not used for college. If your child does not attend college, or does not need all the money in your 529 account, you must pay tax and a 10% penalty on any gains when you withdraw the money. Some college expenses are not approved educational expenses and attract the same tax and penalty. (4) However, many common college expenses are approved. Here is a full list.
• High fees on advisor-connected plans. 529 savings plans connected to the large Wall Street banks typically have very high fees – over 1.5% annually, compared to 0.25 – 0.5% for “retail plans”. Avoid them.

How much can you contribute?

Each state enforces a specific limit on a 529 account’s size, usually between $300,000 and $500,000. There are no annual giving limits.

To avoid having to report a gift to the IRS, give no more than the maximum that you can give as a gift to any one person without triggering gift tax. In 2016, the max is $14,000

There is a unique rule for 529s. You can give $70,000 (5 years’ worth of contributions) as long as you do not make a gift the next four years. The benefit: more time for the money to grow tax-free. High net worth families should consider this strategy soon after a child is born.

Other important 529 rules

• Only one owner and one beneficiary. The owner is usually a parent or grandparent, but can be anyone.
• Multiple 529s okay. A person can be the beneficiary of multiple accounts – for example, from a parent and a grandparent. A person can own more than one account – for example, a parent may own a separate 529 for each of their children.
• Can move money between 529s. There is no penalty to move money between accounts. For example, if you have 529s for your three children and your oldest did not need all the money, the owner can move money to a younger child’s 529. You can also set up a 529 and move the money to another relative.
• No income restrictions. There are no income restrictions on who can own or contribute to a 529 plan.

How does a 529 plan impact financial aid eligibility?

• If a parent owns the 529 plan, the balance is multiplied by 5.64% in determining a student’s “expected family contribution”.
• If the student owns the 529 directly, it lowers financial aid eligibility, because student-owned assets are assessed at 20% availability.
• If grandparents or someone else owns the 529, there is no initial impact on financial aid. However, once money from a grandparent’s 529 is paid to a university, it reduces financial aid eligibility in future years, because it counts as an asset of the student. If the grandparent can wait, they should delay using the 529 until a student’s final year.

How should you invest a 529?

The best option is usually an “age-based option”. This is a mix of stock and bond mutual funds that starts very aggressive (all or almost all stocks) when the beneficiary is young and has many years to recover from any market decline. The mix automatically, and gradually, becomes more conservative as the beneficiary nears college. That’s the time when he/she should not take risk, because they cannot wait for the market to recover if it falls sharply.

Does it matter which state’s 529 you use?

Yes. There are two considerations:

1. State tax break. If you live in a state that offers a state tax deduction for contributions, you should almost always use your state’s plan. Here is a good analysis.
2. Fees. Check the fees on the investment options in a state’s plan. If they don’t offer an “age-based plan” with annual fees below 0.5%, look elsewhere.

Notes

1. U.S. Securities and Exchange Commission. Introduction to 529 Plans.
2. The Ultimate Guide to Understanding 529 College Savings Plans, US News & World Report.
3. Name the Top 7 Benefits of 529 Plans, www.savingforcollege.com.
4. 4 Potential Drawbacks of 529 Plans and How to Minimize Them, US News & World Report.

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