What You Need to Know About 529 Plans

Posted March 8, 2014, 7:00 pm by Kristen Licciardi

“How will we EVER afford college?” For most parents, this question can cause overwhelming anxiety as their children reach the teen years. Paying for college can feel like an insurmountable task on par with climbing Mt. Everest. Parents are right to worry: Tuition costs and fees at public universities tripled over the past 30 years when adjusted for inflation, according to the College Board’s annual report on college pricing.

As higher education costs take a bigger bite out of our paychecks, families are turning to 529 plans to jump-start their college savings. There are now more than 11 million 529 savings accounts nationwide, with consumers investing a whopping $205 billion in these plans, according to the College Savings Plans Network, a clearinghouse for 529 plan information. With every state sponsoring at least one type of plan, the options can be overwhelming. To help you decipher the details, we’ve answered some frequently asked questions about 529s.

How is a 529 plan different?

Unlike traditional investments such as IRAs, mutual funds, or stocks, college savings plans are “tax-advantaged” to encourage families to save for college. Any withdrawals you make from a 529 plan are free from federal income tax (and most state taxes) as long as they are used for eligible higher education expenses— an appealing benefit when you’re trying to make every penny count for college.

How many types of 529 plans are there?

There are two very different types of 529 plans: Prepaid tuition plans and college savings plans.

• Prepaid tuition plans allow you to lock in today’s tuition rates for future use at a participating college or university; you purchase amounts of tuition to be used at a later date by your child. Owners of prepaid tuition plans don’t have to worry about future tuition hikes, as most states guarantee that their prepaid plans will keep pace with rising tuition costs, according to the College Savings Plans Network. The downside? Prepaid plans cover tuition but usually exclude other big-ticket expenses such as room and board. Plus, most state plans require residency to open an account, and the child must attend college in-state (although there are some programs like Massachusetts’ U.Plan, which allows non-residents to prepay tuition at 80 colleges and universities, both public and private).

• College savings plans are the more popular 529 option because of their flexibility. Anyone can open an account in a child’s name (family, friend, or relative). You use the college savings plan to pay for all eligible higher ed expenses at most U.S. colleges and universities. Most states now offer at least one plan that has no residency restrictions, according to Smart Saving for College, FINRA’s (Financial Industry Regulatory Authority) guide to college savings options.

So, for example, you could live in New Jersey, contribute to a plan in Rhode Island, and send your child to college in California. How do you invest your money? College savings plans vary by state but usually offer a selection of investment options like stock or money market funds; you have the flexibility to make as many contributions to the fund as you like; and the beneficiary of the fund can be changed at any point (so an account set up for a child can be transferred to the mother if she decides to go back to grad school, for example).

College savings plans sound so appealing. Are there any drawbacks?

An important caveat: If you withdraw college savings funds for anything other than qualified educational expenses, you’re subject to income tax and an additional 10 percent federal tax penalty on earnings. In other words, don’t plan on tapping into 529 funds to renovate your kitchen. Another drawback: Unlike prepaid tuition plans, these funds don’t lock in tuition prices, and stock market ups and downs can impact your college savings plan year-to-year, depending on the types of funds you own. That’s why financial advisors agree it’s important to start a college savings plan as far in advance of college as possible— so you can take full advantage of the stock market and still have time to move your money into less volatile funds as your child approaches college.

Does this mean it is too late to open a 529 plan if I have a teen?

It depends on the type of plan. It might be too late to open a prepaid tuition plan; most states require the beneficiary to be no older than 15 when opening one. However, it’s not too late to open a college savings plan, as there are no age restrictions and the funds don’t expire when your child graduates from college (they can be transferred to another child or family member at any time). But the longer you wait to open a col- lege savings plan, the less time you have to invest and weather the stock market. So if you open this type of fund at a late date, don’t count on it covering the entire cost of college; you will have to consider additional financing options when tuition bills become a reality.

Will a 529 plan impact my child’s financial aid package?

“Any investments or savings can affect federal financial aid eligibility,” says George Smaragdis, FINRA spokesman. “But the impact on financial aid varies depending on whether the savings belong to the parent or the child.” Here’s how college savings funds are beneficial during the financial aid review: Savings plans are considered parental assets, which reduce your federal financial aid package by at most 5.64 percent. However, a student asset (a savings account in your child’s name, for example) can reduce aid eligibility by 20 percent. The bottom line: Children’s assets are penalized more heavily in the financial aid evaluation process; 529 plans allow you or other relatives to contribute to your child’s education while also minimizing financial aid repercussions for your family.

What about merit-based aid? Will a 529 plan reduce my child’s merit scholarship?

Parents, take note: Your family’s 529 plan will not necessarily reduce merit-based aid your child might receive. There are two sides to financial aid: need-based and merit-based aid, notes Judy Zodda, Educational Consultant and founder of Zodda College Services. “Many parents don’t realize that merit aid can be a big part of your child’s financial aid package, even if you think you won’t qualify for need-based aid.” Merit scholarships vary widely college to college based on an institution’s priorities and can be awarded to students based on good grades, for instance, or musical, leadership, or dramatic ability. Merit aid is also awarded for state residency, minority status, ROTC participation, or alumni affiliation, she says.

With so many options and caveats, how do I pick a plan?

Research 529 plans thoroughly; see our list of web resources to help you compare and understand your options. If you’re overwhelmed by your choices and skittish of potential risks, consider consult- ing a financial expert. “Every family has different needs based on their financial situation. I advise my clients to sit down with a certified financial accountant or certified financial planner who special- izes in college savings and financial
aid to help them assess their options,” says Zodda. “If you haven’t done it yet, have an in-depth talk about saving for college and what’s best for your family’s needs. Start the conversation as early as possible—don’t wait until your child’s junior year of high school.”

For more information on saving for college, go to these websites:

College Savings Plans Network (affiliate of National Association of State Treasurers): collegesavings.org

Serves as a clearinghouse for information among existing 529 plans
Provides links to each state’s 529 plan website as well as tools to compare plans by state and by feature

FINRA (Financial Industry Regulatory Authority): finra.org

College Savings Calculator estimates amount of money to invest each year to cover your child’s college education
529 Plan Expense Analyzer compares fees and expenses of college savings plans and how they can reduce returns
Download Smart Saving for College, FINRA’s extensive overview of college savings tools and resources for families

Big Future by the College Board: bigfuture.collegeboard.org

Comprehensive college planning website
Tools and calculators help you plan how much to save for college, find scholarships, and get a personalized estimate of what a particular college could cost your family

To read more articles from this issue of Life with Teens, check out our digital guides!

Kristen Licciardi

Kristen Licciardi is a freelance writer living in New Jersey and a mother of three boys. She started her career in the editorial department of Glamour and spent many years in marketing positions at magazines including Redbook, U.S. News &World Report and Time. She made the leap into the digital world, working most recently at Slate and Washington Post Digital.

Tags: For Parents