529 Accounts and Beyond

529 Accounts

529 plans are state-run college savings vehicles that solve a lot of the problems checking and savings accounts pose. Designed to help you maximize your educational savings, 529 accounts provide federal (and sometimes state) tax incentives and subtract from your financial aid package far less than funds in checking and savings accounts. 529 plans are available in all 50 states, can be used at two and four-year accredited US institutions, and come in two varieties—college savings plans and prepaid plans. Both varieties follow the same basic rules:

• Funds stored in either a 529 college savings plan or a 529 prepaid tuition plan grow tax deferred and when the student is ready to attend school, distributions come out federal income tax free. Some states also offer a break on state income tax.

• 529 funds can only be used for educational expenses. If a student decides to attend a foreign institution or to not attend college at all, 529 funds can be rolled over to another relative or can be withdrawn, but the family will have to pay a 10 percent penalty on earnings.

• Parents are financial kings with 529 plans. Even if a plan is in a student's name, parents maintain control of the funds and can decide when and if to pull funds out. So much for using that money for a new Porsche.

• 529 plans only subtract a little from a student's federal financial aid package. Unlike checking and savings account funds which can be assessed at a 20 percent rate, 529 funds are assessed at a 5.64 percent rate regardless of whether the account is in the parent's or child's name. In layman's terms, one dollar in a 529 account is only going to cost you up to 6 cents in financial aid. 

• Parents, family members, and anyone else who loves you can contribute. In fact, 529 plans basically encourage well-off relatives to unload their dough on you by including a loophole that allows donors to gift up to $60,000 to your 529 at once without paying gift tax. That probably sounds like the driest, least important fact on earth right now, but trust us. When your aging auntie hears that she can hand you a boatload of money instead of paying an enormous tax to the government, it will be music to her elderly ears.

There are a few substantial differences between 529 college savings plans and 529 prepaid plans. Here is how each works:

529 Prepaid Tuition Plans

Prepaid tuition plans are investments in the truest sense of the word. Only available in a handful of states nationwide, prepaid plans allow families to purchase "tuition units" at a price that's above the current cost of college. Years later, when their child is old enough to attend school, families can use their prepaid tuition credits to pay for college regardless of how high college tuition is in the future. Parents essentially pay today, cash in tomorrow, and sidestep all of the crazy tuition inflation that happens in the mean time. Cha-Ching! Considering that there's no risk involved in a prepaid plan AND that the average college increases its tuition approximately 8 percent each year—meaning that a school that costs $20,000 per year today will cost more than $43,000 a decade from now—prepaid plans can be an A-MAZE-ING deal for families.

But here is the thing with prepaid plans—they come with a good deal of red tape. Prepaid plans only cover tuition and fees (not room and board) and are designed to be used at public in-state colleges. Students who attend a private college or out-of-state school can use money stored in their prepaid plans to pay for college, but in most states, they will only be able to use the money they've put in with little to no interest added. That's the financial equivalent of keeping your college savings in your little sister's piggy bank for your entire life.

College Savings Cheat Sheet: 529 Prepaid Tuition Plans

Accessibility: Low. Families can only get full value from prepaid tuition funds by using them at a public, in-state institution. If the student does not go to college, parents can roll over funds or pay a 10 percent penalty on earnings to pull them out.
Risk Level: Zero :)
Rate of Return: Excellent for in-state students, terrible for everyone else :
Tax Benefits: Federal and sometimes state tax breaks :)
Impact On Your Financial Aid: Moderate :

529 College Savings Plans

Those complaining about the restrictions of 529 prepaid plans can bask in the warm fiscal glow of 529 college savings plans. Ever played the stock market game? These plans are basically the real life version. 529 college savings plans provide families with their choice of several investment portfolios that range from conservative to aggressive. Parents choose one portfolio option—which can include stock, index fund, bond, and/or securities options—and watch their savings go up or down along with the markets. If you are stressed that your family will not be able to choose the right investment portfolio, you can use an advisor (although they are not necessarily perfect either). 529 college savings plans come in two forms—direct-sold plans where you make all the investment decisions and broker-sold plans where a financial advisor does that for you in exchange for a (sometimes hefty) fee.  If you opt for a 529 college savings plan, investigate whether your state offers a tax break (a list of plans that do can be found here) and compare fees from plan to plan. Even a 1 percent difference on advisory fees can add to significant cost over time.

529 college savings plans have a number of advantages over their prepaid counterparts:

• Money stashed in these bad boys can be used at any accredited institution nationwide. You will not lose a dime by going out of state or to a private school. 

• 529 college savings funds can be used for any educational expense; not just tuition and fees.

• The sky is the limit with these plans. Invest well and with some luck, your account could earn some serious dough.

The major drawback is that unlike prepaid plans, 529 college savings plans come with risk...too much risk if you ask those who saw their accounts drop by 30 or 40 percent since the market crashed in 2008. While you can earn a bundle by playing your monetary cards right, you can also watch your savings disappear into oblivion. Choosing a reasonable portfolio and shifting funds to less risky investment options as your child approaches college age are crucial in making these plans pay off.

College Savings Cheat Sheet: 529 College Savings Plans

Accessibility: High. These plans are good at nearly all US two-year, four-year schools, vocational, and technical schools :)
Risk Level: Low to High depending on how risky your investment portfolio is :
Rate of Return: That depends on how well the market performs :
Tax Benefits: Federal and sometimes state tax breaks :)
Impact On Your Financial Aid: Moderate :

Given the high savings threshold and generous tax incentives, it is not surprising that 529 plans are one of the best values in college savings...but they are not the best fiscal decision for every family. For students who are unsure if college is the right move and for families who may need to access their funds before their student reaches college age, here are some other investment options.