Getting Educated About 529 Plans

At current growth rates, college bills for kids born today may exceed $300,000. It's time to prepare.
Author:
Publish date:

Most of us look back on our college careers and fondly smile at those four years of unbridled happiness. Those were good times.

Now, as a mother of three, it makes me nauseated to think that my son may some day be in a fraternity and that my daughters will, well, some day be in a fraternity.

Unfortunately, there's this pesky societal requirement that a kid needs at least a bachelor's degree to get a decent job these days. So I have no choice but to unleash my children to this debauchery and hope that they learn something in the process.

To make matters worse, I must now start saving for what will probably be the most expensive party of their lives. With private tuition already at $30,000 a year, presuming a 6% annual increase, I'm looking at a $300,000 party by the time my 18-month-old youngest sweetie is driving on to campus. (Again, I'm nauseated.)

So I've decided to open 529 plans.

There are two types of 529 plans out there: the prepaid college tuition plan or the college savings plan. The first, as its name suggests, lets you prepay tuition at your state's colleges. The latter is just like a 401(k) account, and the money can be used at any school in the country. So the college savings plans are the more logical option.

These plans are mostly run by the big mutual fund houses such as

Fidelity

,

Vanguard

,

T. Rowe Price

(TROW) - Get Report

and

TIAA-CREF

. While each state has its own plan, they're generally open to anyone, so don't let the so-called administering state confuse you. If you live in New Jersey and want to get into Ohio's plan, which is run by Vanguard, you're allowed. It's really just the name on the brochure.

Following are three reasons why I think the plans are great and three reasons why you should look before you leap.

The Good

The tax benefits are fabulous

. You can contribute up to $300,000 in after-tax dollars to most 529 accounts. Then, as long as the beneficiary uses the proceeds for college expenses, withdrawals are completely tax-free. So that means you won't owe tax on the earnings. That alone makes these plans worthy of consideration.

If you're really looking to jump-start Junior's account, you can contribute up to $12,000 per year (or $24,000 as a married couple) without incurring a tax on the gift. And for anyone who needs to get money out of her estate (hello, Grandma!), she could make a lump-sum contribution of $60,000 ($120,000 for a married couple) without any adverse gift or estate-tax consequences, provided she doesn't make any additional contributions to that account for the next five years.

Even better, at this point, 26 states and the District of Columbia offer state tax benefits as well. For instance, if you're a New York resident and invest in the state's 529 savings plan, currently run by Vanguard, you could get a state income tax deduction of up to $5,000 ($10,000 for married couples filing jointly).

Other states offer different incentives. While New Jersey doesn't offer a state tax deduction, it will kick in a $1,500 scholarship if you open the state's 529 plan and your kid ends up at a Jersey school. Hey, it's something.

These 529 plans don't affect your child's eligibility for financial aid.

That's because the account is not in the child's name. The child is merely the beneficiary. And when schools calculate financial aid, they place the most emphasis on the assets in your kid's name. That's why a custodial account such as an UTMA -- Uniform Transfer to Minors Act account -- can hurt your kid's financial aid chances. Theoretically, that account is in his name and is his for the taking when he reaches the age of majority in your state. So for financial aid purposes, the lower amount of assets in your kid's name, the better.

For someone like me -- and I'm sure many people out there -- this is very important point, because even with all my savings attempts, I'll still probably come up short and need some additional financial help.

These 529 plans have a ton of investment options these days.

Whether you want to invest aggressively or throw it all in conservative CD options, there's a plan out there that will fit your needs.

And many offer my favorite, age-based portfolios where the equity and fixed-income ratios are automatically adjusted each year as your kid gets closer to college. So for instance, if you opened an age-based account for your newborn in Fidelity's UNIQUE 529 plan, sponsored by the state of New Hampshire, about 87% would be in equity funds at the time of his birth. By the time that kid is 16, that equity holding would drop to around 50% to become more conservative. This change in allocation is done automatically. You don't have to do a thing -- just keep contributing.

The Bad and the Ugly

You might lose some tax benefits.

The way the current law is written, the ability to withdraw earnings tax-free will disappear in 2011, although most pros believe that the folks in D.C. will extend this perk.

If by chance, Congress does not allow it (fools), then you'll still most likely get the benefit of the tax-deferred earnings, but your child would then owe tax on the earnings at withdrawal, says Matt McGrath, senior VP at the financial planning house of Evensky & Katz in Coral Gables, Fla. But it's likely that your kid will be in a lower tax bracket, so the tax hit might not be so bad.

And remember, if Junior doesn't go to college, and you don't have anyone to turn the account over to, you'll owe a 10% penalty on the money plus tax on the earnings. You can always redirect the account to another student -- including yourself -- but you can't take the money out to fund your child's cross-country trip, as educational as that may sound, without incurring the penalty.

Researching these plans can get overwhelming.

With more than 50 plans available, where do youbegin?

First, go to the Web and start learning.

Savingforcollege.com is a great place to start. There's a great

calculator that will clue you in to how much money you're really going to need.

After you scrape yourself off the floor, look to your own state's plan first, suggests Joe Hurley, the Web site's founder. If the plan is a good one and there are state tax benefits, you may not want to pass those up.

"Then beyond that, selecting a plan is much like selecting a mutual fund," says Hurley. First, check out the different investment options. If, for instance, you're conservative, make sure the plan you choose has lots of fixed-income options.

Then read up on the minimum investment requirements. Some plans require a few thousand dollars to open the account. Others will take just $50 if you commit to automatic monthly contributions.

Be sure to check out Vanguard's

comparison tool, which allows you to compare two plans against each other.

Finally, be aware of high fees and other penalties.

Just like mutual funds, 529 plans can charge lofty fees that essentially eat away at your earnings. Some plans' fees can be as high as 2%, whereas others are only 0.58%. So read the fine print.

Each February, Morningstar.com puts out a report that rates all the plans and their corresponding fees, so be sure to check it out.

What's worse, in an effort to stay competitive, some plans are imposing penalties on residents who invest elsewhere. As an example, Illinois has started imposing a 3% state tax on the earnings residents receive from another state's plan. Horrible.

So do your homework. Saving for anything is hard enough, so the last thing you want to do is lose Junior's beer money to extraneous fees and penalties.

Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback; click here to send her an email.