529 Plans Primer: What Exactly is a 529 Plan?

You’ve just had your second child and your oldest is 2 years old. The last thing on your mind is college.  Are you kidding me? You’re not even sure why you went to college when you’re up to your eyeballs in spit-up and sibling rivalry, but, unfortunately, these things need planning.

Today’s Smile & Nod is a quick guide to 529 plans. I will do a blog post on the pros and cons of 529s and another post on pre-paid versus savings plans, but today I’m just going to talk about what a 529 is.  First, a few definitions: beneficiary is a person who will use the funds to pay for education; and post-secondary education means college (2 or 4 yr), or graduate school. The IRS rule of thumb is: any institution (including foreign, private, public or for-profit) eligible to participate in any student aid program run by the dept. of education (financial aid) is a qualified post-secondary institution.

Plans come in two types: Pre-paid and savings plans. Only states can have savings plans, but states and educational institutions can have pre-paid plans. Pre-paid plans mean you can buy units (credits at prices for a credit on the day you deposit the funds) in your in-state public college. Pre-paid plans can be converted to private or out of state colleges too (see your plan for details).  Most pre-paid plans require the owner or beneficiary to live in the state. Savings plans are just like a 401k, where deferred tax deposits grow and are used for post-secondary school of the beneficiary.

Here’s the bullet point guide of what you need to know. With a 529 plan (although some points are the same, these points are for a savings plan, I will talk about pre-paid plans in another article):

  • You may pay “load” or fees for the management of your funds in a 529 plan, but look for a “direct-sold”529, which may avoid fees
  • your deposits are not deductible on your federal income tax
  • you can deposit at any time whether you child is 1 or 17 or not born yet
  • the beneficiary does not need to be your child
  • when you withdraw the funds to pay for post-secondary education of the beneficiary, the funds are not taxed (unless you live in Alabama, but that’s another story)
  • you can change the name of the beneficiary during the life of the 529 account
  • you can roll the funds over into another state’s program whenever you want, but if it is for the same beneficiary, it can only be done once per 12 month period
  • you can use the funds to pay for tuition, books, fees, equipment, student special needs or room/board (as long as the beneficiary is at least a half-time student)
  • you can enroll in a 529 plan in any state: you can live in CA, enroll in a plan in MI and your beneficiary can go to college in FL – no problem
  • you are in control of the account, the beneficiary cannot touch it. You have to make the withdrawal when your beneficiary is ready for school
  • if you withdraw the funds and do not use them for the beneficiary’s post-secondary schooling, the amount you earned over the life of the account is subject to 10% penalty
  • the principal, amount you deposit  (once or many deposits) is not subject to the penalty
  • if you withdraw funds and do not use them for the beneficiary’s post-secondary schooling, earnings on the account are subject to federal and state tax. They are taxed as ordinary income (ouch!) just like your salary or bonus
  • you can deposit a lot or a little (some states up to $300,000) and it can be in one deposit or every paycheck by direct deposit
  • your funds are professionally managed by the plan, but you can change your investment program once per year (in most plans, so double check your plan on this)
  • Assets in a 529 plan are counted as parental assets when applying for financial aid and therefore part of the Expected Family Contribution (EFC).

The next post will talk about the 529 Savings versus Pre-paid Plans. Also, look for my blog post about the pros and cons of 529 plans.