How to Choose a Tax-Advantaged Account for College Saving, Part 1

René Nourse, CFP® |

To keep pace with the rising cost of higher education, which has skyrocketed more than 500% since the mid- 1980s, parents and caregivers need to start saving as soon as possible in order to avoid potentially large loan payments. While scholarships, grants, and other gifts of money to attend universities are still desirable, it’s important to look at all the options for setting aside college dollars in a variety of different tax-efficient investment accounts. In the first of a three-blog series, we will look at one of the most popular options: the 529 plan.

529 Plans

If you’ve started to look into college savings programs, you’ve probably heard of the most popular option, otherwise known as the 529 plan.

Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions. You don’t have to be a resident of a particular state to set up a 529 Plan in it, nor are there any age limitations in setting one up: anyone at any point in their life can set up a 529 Plan for themselves or a beneficiary. You can also set up as many 529 Plans as you like—there are no limits on how many you can have. 529 Plans are administered by investment companies, which also oversee the underlying investments.

There are two main types:

Prepaid tuition plans let participants pay for future tuition at today's rates, essentially taking inflation out of the equation. These plans are typically available only to residents of the sponsoring state and are often be intended to cover in-state university tuition. participants might be able to use the money at out-of-state schools, but in some cases only a reduced percentage of the balance. While California does not offer a prepaid tuition plan in this sense, the college savings plans they do offer include elements of prepaid tuition plans by offering a guaranteed investment option.

College savings plans let participants invest their contributions in portfolios of mutual funds or similar managed financial instruments. Money in a college savings plan can be used for qualified undergraduate and graduate expenses at any accredited college or university. With some 529 college savings plans, contributions are allocated to a particular portfolio based on the child's age. As the child nears college age, the money shifts to different portfolios with appropriate risk and return potential. Other 529 plans offer greater investment flexibility, letting the account holder choose from a range of securities.

The potential advantages of 529 plans include:

  • Tax-free earnings. Earnings in a 529 plan accumulate free from taxes, and qualified withdrawals are federally tax-free. Withdrawals may be exempt from state taxes as well—although not in California, where no state income tax breaks are offered from 529 contributions. Non-qualified withdrawals from a 529 plan may be subject to income taxes and a 10% additional federal tax.
  • Gift tax benefits for contributors. A contribution to a 529 plan is considered a gift for federal tax purposes. Tax rules in 2015 currently let you give up to $14,000 to as many individuals as you choose, free from federal gift taxes. Gifting schedules can also be accelerated through a lump-sum contribution of $70,000 to a 529 plan in the first year of a five-year period.
  • Generous contribution rules. Lifetime contribution limits on 529 plans vary from state to state, but often exceed $200,000 per beneficiary, including earnings. In addition, there usually are no income restrictions on contributors to a 529 plan.
  • Account control. The individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account and account owners may also change beneficiaries without tax consequences.

Finally, contributions to 529 plans may provide a state tax deduction for residents of the sponsoring state. To identify the 529 plan that best suits your needs, ask the following questions about each one you evaluate:

  • Can you transfer account ownership?
  • What are the contribution limits?
  • Are the investment choices appropriate for your needs?
  • Are there any fees?
  • Is your intended school considered a qualified institution by the IRS?

Working with a financial planner to answer all of these questions will help you choose which type of plan is right for you and your family.

In our next two parts, we will discuss other options, including UGMA/UTMA accounts and Coverdell’s.