Complete Guide to Saving For College with a 529 Plan: Part One

Kristin McKenna

Qualified tuition programs (also called QTPs and 529 plans) are actually quite straightforward by themselves. Plans typically offer simple investment choices such an age-based asset allocation, and they are relatively easy for anyone to establish and fund. For many investors, the hardest part about 529 plans is selecting the right one. Perhaps resulting in a “paradox of choice,” each state is able to start its own QTPs and there is no requirement for parents to select an in-state option. Although there are federal rules in place, states are able to create their own unique set of restrictions, terms, and tax laws. So how should you choose between the 118 qualified tuition programs?

The Guide to 529 Plans is broken up into five sections:

Section 1: An Overview of Qualified Tuition Programs and How They Work

There are two types of 529 plans: prepaid plans and savings plans. There are no income restrictions on who can contribute to a 529 plan. Due to the decline in prepaid plans and their logistical issues, this article will focus primarily on savings plans.

Prepaid 529 plans

Prepaid plans do exactly that, allow parents to pay for their child’s future education at today’s prices. While that may sound like an incredible bargain given the rising costs of higher education, there’s a catch: prepaid plans only cover in-state tuition at public colleges and universities. Since parents often need to start saving for college very early on in their child’s life, prepaid tuition plans almost require a crystal ball. Should your child decide to attend a private or out-of-state university, the state’s rules will dictate how much tuition the plan will cover.

Unlike savings plans, prepaid plans can only be used to cover tuition and fees, not other expenses like room and board. Another risk of prepaid plans is whether the state will actually have sufficient funds to cover the cost. Only a handful of prepaid plans are backed by the full faith and credit of the state. As a result of these issues, some states have stopped offering prepaid plans or terminated the plan entirely. For a complete list, click here.

Savings plans

Savings plans are the more common type of qualified tuition program. In most cases, any U.S. citizen or resident alien over age 18 can open a 529 plan, whether for themselves or someone else. A plan may have only one beneficiary, although that person may be changed to another member of the beneficiary’s family.

Overview of tax benefits: For federal tax purposes, contributions are not deductible and investment earnings are not taxed if distributions are used to pay qualified education expenses at a post-secondary accredited institution. (See Section 2 for an explanation of terms). Many states offer a tax deduction or credit (many subject to annual maximums) for contributions made to an in-state plan. As of the writing of this article, there are six states that provide a tax deduction for contributions made to any state’s 529 plan. Those states are: Arizona, Kansas, Maine, Montana, Missouri, and Pennsylvania.

Overview of investment options: Savings plans provide investors with a limited number of investment options. Choices commonly include:

Age-based options: Plans may provide age-based investment options. As the name implies, the portfolio will be comprised of various underlying funds (usually mutual funds) corresponding to the beneficiary’s age and are designed to become more conservative as the beneficiary approaches college age.
Risk-based options: Plans may offer investment choices based on your risk tolerance as a stand-alone option or as another option within the age-based portfolio.
Static investment options: Pre-constructed portfolios may also be available in 529 plans. Static investment options may be based on risk tolerance and can also include Money Market investments. Plans may offer multi-fund or single fund portfolios. The number of choices will vary considerably among plans.
CDs and other interest-bearing investments: A small number of plans only offer CDs and other investments that may have a fixed interest rate or a minimum interest rate. In today’s low interest rate environment, returns may be insufficient for many investors.