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Many financial advisers consider 529 plans the best weapon in the arsenal when it comes to saving for college. And that weapon just got more potent, as tax law changes taking effect in 2002 have increased the tax advantages and flexibility of the plans.
A 529 college savings plan (529 is the section of the IRS code covering the plans) is set up by a state to allow families to invest for college. Almost all states have a plan, or are developing one, and many have hired one of the large mutual fund companies to run their programs. Many states allow residents of other states to invest, so consumers are free to shop around for the plan that best meets their needs.
These plans are becoming popular because the money grows tax-free and can be used for a variety of education expenses, including tuition, books, and room and board. Starting this year, withdrawals used to pay qualifying education expenses will be free of federal income tax -- one of the biggest advantages of investing in a 529 rather than a simple mutual fund account.
Unlike some other programs to help families cover college expenses, 529 programs impose no income limits on who can have such an account. How is the money in a 529 invested? That depends on which plan you select. You may be able to choose among tracks in some state plans. Some offer very low-risk options, where your money is invested in certificates of deposit, for example. Others offer more aggressive options. Many plans use a model portfolio, based on the age of the beneficiary or the year the child is likely to enter college. As the child gets closer to college age, money will be shifted out of the stock market and into bonds and other investments with less risk than stocks. Other than a few low-risk options offered by certain states, there is no guarantee how much your investment will grow. Like the stock market, many 529s took a big hit in 2001.
Once you've chosen the investment "track" you want, you have to sit back and let the fund managers do the rest. Starting this year, you have the option of changing "tracks" -- or even moving your account to another state's plan -- once a year. Previously, such changes were more difficult.
With several dozen 529 plans to choose from, there's plenty to consider in selecting the one that's right for you. "Each program has unique features and rules, and is subject to the laws of the sponsoring state," said Joe Hurley, a CPA and author of "The Best Way to Save for College - A Complete Guide to 529 Plans." When considering a 529 plan, Hurley suggests investigating:
- Are there any special advantages to sticking with your home state's plan? Some states give residents a tax break on contributions to the state 529 plan, for example. Others give residents a discount on fees.
- What are the limits? Depending on your investment style, you might be concerned about finding a fund that will let you start small -- and you can open some accounts for $100 or less. On the other end of the scale, states also impose a maximum amount that can be deposited in each beneficiary's account -- $250,000 in some states, but much less in others. If you want to sock away enough so that your child can afford a prestigious private university, you'll need to seek out a 529 with an adequate cap on investments.
- How's it invested? Look for a plan that offers an investment option that "matches your own objectives and asset allocation preferences," Hurley said.
- What's it going to cost? Lower expense ratios mean more money for your student in the long run. Also check on enrollments fees, annual management fees or other costs.
Make sure the program manager makes thorough disclosures and provides adequate administrative support. Flexibility -- the ability to make changes in beneficiary and investment strategies to the full extent allowed by the law -- is another area worth looking into, Hurley said.
One of the best sources of 529 information is Hurley's Web site, www.savingforcollege.com , where you'll find links to state plans, comparisons of various 529 programs, news about returns, and FAQs.
While 529 plans offer families many advantages in the quest to save for college expenses, there are some downsides to the plans, Hurley noted. "529 plans are confusing … They tend to make frequent changes as IRS rules are clarified and the increased competition leads to innovation," he said.
Additionally, as the tax exemption enacted in 2001 is only effective through 2010, future tax law remains uncertain, he added. And, "financial aid treatment [how the 529 plan assets are treated in the formula determining how much aid a student may qualify for] is uncertain as well and may be changing."
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