The cost of sending a kid to college is skyrocketing at a rate that has surpassed the rate of inflation for each of the last five years, according to the College Board. That makes saving for college a high priority for parents or guardians who wish for their children to get an undergraduate education. Many consumers are turning to 529 college savings programs (named after the section of the IRS code in which they appear) to help pay for higher education.
There are more than a hundred 529 plans to choose from, and every state offers at least one. CollegeSavings.org provides a list of plans available by state, as well as the opportunity to compare the key points of different plans.
The good news is that most plans are available to all U.S. residents, regardless of where someone lives. And in many cases investments can be used for institutions located anywhere in the country. That means a person could live in California, contribute to a 529 plan in Ohio and send a child to college in Florida.
This flexibility gives consumers plenty of options. The downside of having so many choices, however, is that a little extra work is needed to find the right plan.
Pre-paid versus savings plans
The two main flavors of 529 plans are pre-paid tuition plans and college savings plans. As the name indicates, pre-paid plans allow parents to purchase future tuition credits for a specific institution or set of institutions at current prices. The advantage here is that parents could conceivably pay all of a 2020 graduate's tuition at State U in 2008 dollars. But most pre-paid plans are restricted to state residents only, as is the case in Michigan, and Maryland. Some states, such as Massachusetts don't have residency restrictions.
In addition, if a student decides to head out of state for college, parents could lose the guaranteed tuition rates -- although they will be able to take most of their contributions with them. (This equals generally the average tuition rate for the state in which you held the plan.) Finally, pre-paid plans often have restrictions on enrollment. The Massachusetts plan, for example, only allows enrollment from May 1 through the end of June.
Given the restrictions on pre-paid plans, it's not surprising that savings plans are a more popular 529 option. These plans consist of a managed investment account that grows tax free. Money saved in these plans can be used to pay for eligible college expenses such as tuition, room and board, and books. Many plans also allow parents to choose the type of fund in which the money will be invested, such as a target date fund in which the allocation begins heavier in stocks, and then shifts toward less risky investments, such as bonds, as a child nears college age.
The options vary from plan to plan, depending on choices made by the plan sponsor (the state) and the plan manager (the investment company charged with managing the fund).
By federal law, 529 savings plans must cap the total allowable contributions to their plans, but states vary on the amount of that limit. The Gift College Investing Plan in Arkansas has a $245,000 total limit, for example, while the Fidelity Arizona College Savings Plan has a total limit of $318,000. If it's expected a student may yearn for some of the more expensive colleges, parents may want to seek a plan that has a higher contribution limit.
Fees and tax benefits
Investment fees can reduce the growth of any account, including the balance of a 529 savings plan. The fees range from state to state and plan to plan, so a comparison of the plans should be made rather than automatically choosing the in-state plan. Most plans also charge an enrollment fee, along with yearly maintenance and management fees depending on the nature of the plan. Some or all of these fees may be waived if the balance held is high enough in the case of the savings plans, or are in a state that gives perks to in-state residents.
Contributions to a 529 savings plan are made with after-tax dollars. However, investment earnings are free from federal and state taxes (with the exception of a handful of plans including some in Mississippi and Missouri) as long as the money is used to pay for qualified education expenses. Some states also provide tax deductions for a certain portion of contributions to in-state plans. For example, Maine residents can deduct up to $250 of their contribution to the state plan this year, while California residents aren't allowed to take any 529-related deductions. Knowing what perks a state offers can help determine whether someone is better off sticking with the state plan or searching elsewhere.
There's another way to save money with a 529 plan: Most plans allow parents or guardians to buy directly from the plan sponsor via a "direct-sold" plan. The alternative is buying into a plan through a broker or sales agent in a "broker-sold" plan. If going with a broker, an additional enrollment fee, a withdrawal fee and/or an annual distribution fee, will have to be paid. These fees vary depending on the broker and the plan, but some can be upwards of 5% for the initial enrollment fee and from 0.25% to 1% for the annual distribution fees.