529 Plans (Qualified Tuition Programs)
529 plan background
These accounts allow for mutual fund investment within a tax-free account. And qualified distributions to pay for college tuition, board, or supplies are also tax-free. 529 plans grew out of pre-paid college tuition accounts. These accounts were severely limited in that there were no investments; rather, there was a guarantee that the company holding the money would pay the annual inflationary rate of school costs into the account. Pre-paid tuition contracts also limited the beneficiaries to attending state schools within their resident states.
Thankfully, the 529 world has changed in many ways. Those interested in 529 plans are not restricted to obtaining a plan only from their resident state, and beneficiaries are no longer required to go to school in the state of the plan.
529 plans currently allow an annual contribution of $13,000 (the annualized gifting amount) or a choice of prorating five years of gifting ($65,000) all at once. Most plans have preallocated portfolios based on the age of the beneficiary, but others may allow direct mutual fund investment or investment within bank CDs. All qualified distributions must be used for a college or trade school and may not be used for elementary or secondary school costs as the Education IRA can. Overall, account maximums will vary from state to state but should be between $150,000 and $250,000 per beneficiary.
One of the most compelling aspects of the 529 plan is the owner's ability to maintain control throughout the life of the account. Custodial accounts and Education IRAs have age restrictions on the beneficiary, and the owner will eventually lose control of the account due to those restrictions. The 529 plan has no age restrictions on the beneficiary and no date upon which the owner would have to give up control of the account. Wrapped into this is the owner's ability to change the beneficiary to another member of the family—daughter, son, cousin, nephew, niece, uncle, aunt—as many times as he or she likes (limit of once per calendar year).
Note on financial aid
All 529 plans will affect your child's chances of qualifying for financial aid. The U.S. Department of Education says that a 529 savings account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution toward your child's college costs will include 5.6%, or less, of the value of your account for each academic year.
The fees, expenses and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee a college-funding goal will be met. Under current federal tax law, the tax-free treatment of qualified 529 plan distributions ends December 31, 2010.
Earnings must be used to pay for qualified higher education expenses to be federally tax-free. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient's marginal rate and subject to a 10-percent penalty.