TheStreet

A college 529 plan is a very effective - if under-used - investment vehicle that helps families save for college in a tax-friendly manner.

Unfortunately, 529 plans seem to be flying under the radar of U.S. college-bound families who are already struggling to pay for the soaring cost of college.

In fact, a substantial majority of American families aren't even aware of college 529 plans and their value.

According to a recent study by Edward Jones, 71% of Americans don't know what a 529 plan is, never mind what value it provides in the college savings experience.

Additionally:

  • Just 29% of Americans correctly identified a 529 plan as a college savings tool.
  • 52% of U.S. adults with incomes of $100,000 or more correctly identified a 529 plan versus just 17% of those with less than $35,000.
  • College 529 plans rank low on the priority list of college-savings U.S. households. According to Edward Jones, 42% of Americans used, or plan to use, their personal savings to pay for higher education expenses, followed by scholarships (33%), federal or state financial aid (31%, and private student loans (20%), with 529 plans finally clocking in at 13%.

Families saving for college would be doing themselves a big favor by getting to know all about college 529 plans - and here's a good place to start.

What Are College 529 Plans?

A college 529 plan is a tax-advantaged savings and investment plan that has one essential mission - to save for future family education costs.

College 529 plans, also called qualified tuition plans, are sponsored by government entities, mostly states and state agencies assisted by public and private educational institutions. College 529 plans are authorized by Section 529 of the Internal Revenue Code.

College 529 plans primarily come in two models - prepaid tuition plans and college savings plans:

  • Prepaid tuition plans. A prepaid college tuition plan enables college-bound families to pay for college costs at an in-state college or university in advance. These plans, often offered by educational institutions, can also a degree of flexibility, as they can be converted for payments at private and out-of-state public colleges and universities, as well.
  • College savings plans. These types of college 529 plans are a mirror-image of traditional Roth 401k or Roth IRA plans. Like Roth retirement plans, college savings plans allow for the investment of after-tax funds in specific investment vehicles like mutual funds, exchange-traded funds, or bank certificate of deposit or money market account. Like most retirement savings plans, 529s are stocked with mutual funds and ETFs, so the savings can and does rise and fall in value depending on market conditions.

When you do start spending 529 dollars, there is a specific list of college-related costs you can pay for. That list, known as qualified education expenses, includes:

  • College tuition
  • Mandatory college fees
  • Study tools like a computer, e-reader, laptop or mobile phone
  • Books and supplies
  • Room and board

College 529 plans also offer flexibility in enrollment rights, as well.

With these plans, U.S. households can open a 529 account and name anyone the beneficiary. If that beneficiary decides he or she does not want to attend college, the account holder can easily switch beneficiaries, to anyone he or she pleases, who wants to go on to college.

Tax-wise, college 529 plans consist of after-tax dollars that grow on a tax-deferred basis. When the money is pulled out of the plan, it's done so with no federal taxation involved in the transaction, as long as the withdrawal cash is used for approved college costs.

If a college 529 plan holder is audited by the IRS, and the tax agency rules that 529 plan assets were used for unqualified expenses, then the earnings portion of that withdrawal will be taxed by Uncle Sam, with a 10% penalty added into the mix.

Choosing 529 Plan Investments

Choosing a specific investment account to use for college funding depends on the age of the recipient.

By and large, the younger the recipient, the more benefits are in play with a 529 plan. The most significant upside of a 529 plan is on the constant growth of plan assets.

Much depends on the age of the potential recipient at the time the plan is opened. If your child only has a few years left before school, the expected asset growth in a 529 plan is limited. On the other hand, the younger your child is when the plan is opened, the more time the money has to grow - and on a tax-free basis.

Investment-wise, the age issue matters, as well.

If your plan recipient is within four years of college then a 529 account with a basic high-yield savings component is a smart investment. While you are giving up the possibility of larger investment gains earned from stock funds, with a high yield savings component, you're ensuring no possibility of investment loss.

In contrast, if you had $5,000 and kept it in stock funds and the market tanked, you could be in big trouble, college savings-wise. If the account value declines to $2,000, there's no time to make the money back.

That's why an age-appropriate investment strategy is a savvy move for a college 529 plan.

During any 15-year period, the stock market may decline by 10% several times. Consequently, it's not realistic to believe you'll avoid all investment risk. That's where an age-based asset allocation comes in handy. When the recipient is young, say 3 years old, the amount invested is low and there is more time to recover from losses, so you can be more aggressive in the mix of investments.

Fast-forward 12 years later, as college approaches, the idea is to slide over to a more conservative mix of investments, where there is less risk of loss. That strategy protects the college savings plan from big losses. You don't want to be invested entirely in an all-stock fund when the S&P 500 drops by almost 40%, as it did in 2008, wiping out most or all of college 529 plan investment gains at the time.

What to Remember With College 529 Plans

Here are four primary points about 529 Plans:

1. Any individual can open and contribute to a 529 Plan on behalf of a young beneficiary. That includes parents, grandparents, relatives and friends.

2. There is no specific cash amount that has to be contributed, so income level really doesn't come into play. That said, there are some limits on how much you can contribute.

3. A 529 savings plan offers ample tax advantages. Assets in a 529 Plan grow federal tax-free and withdrawals are tax-free, provided the funds are used for qualified education expenses. The state where you reside offers additional tax benefits for 529 plan holders.

4. They come with multiple investment options. The best investment strategy is when decisions are based on risk level and/or the age of the beneficiary. In most instances, the time horizon makes the investment allocation decision for you. Many plan options offer automatic asset allocation changes as the beneficiary gets closer to college age.

While no investment plan is perfect, college 529 savings plans are as good as it gets when devising strategies to pay for college. They're tax efficient, assets can grow over the years thanks to compound interest, and they're flexible enough to change asset allocations and ensure the money will be there when the recipient heads off to campus. Compare that to taking out burdensome student loans and raiding your retirement account to pay for college and 529 plans look even better. Way better.

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