- Earnings on the underlying investments in a 529 plan accrue free from federal and state taxes, and upon distribution no federal taxes are paid as long as the funds withdrawn are used for eligible educational expenses. Eligible expenses include tuition, fees, books, supplies and any equipment required for studies at an accredited institution of higher education in the United States.
The compounding effect on earnings that accumulate tax-free over time can be significant. - 529 College Savings Plans are administered by each state. Although each state establishes its own plan, administrative and record keeping duties are usually delegated to a third party, usually an investment management company whose mutual funds comprise the available investment options offered to plan participants.
Some states allow generous maximum contributions (up to $300,000), as well as the ability to deduct all or a designated portion of the contributions on a donor's state income tax return. - Savings plans are dependent on market appreciation of the underlying assets, which principally consist of mutual funds. Most savings plans rely on an investment strategy of age-based asset allocation.
During the early years of the plan's existence, investments are more heavily weighted in stocks or other aggressive growth investment vehicles, as denoted by the state's plan administrator. As the child approaches college age, the asset mix within the fund classes is reapportioned to more conservative investments, such as fixed-income bonds or conservative growth stock funds. In some plans, the mutual fund manager performs these asset-class adjustments automatically at the appropriate time. - Prepaid plans, by comparison, allow the donor to purchase future tuition credits at today's rates. Since tuition costs have consistently outpaced the rate of inflation, prepaid plans offer a way for parents to lock-in the current cost of college, to be applied in the future as an inflation hedge, when, if historical trends remain unchanged, tuition costs will be significantly higher.
- Parents should be aware of a significant distinction between savings and prepaid plans. For purposes of 2009 federal financial aid formulas, 100 percent of prepaid plans are considered a parental asset, and as such, may reduce a family's eligibility to receive financial assistance. Savings plans are also treated as a parental resource, but only 5.6 percent of the plan's assets are considered available to offset college costs for each year of enrollment.
Since many states allow non-residents to participate in their 529 plans, parents are free to look out-of-state in cases where any limitations of their particular state plan, including restrictions on investment options, may be too inflexible in light of their particular needs.
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