Sunday, December 24, 2006

529 Plan

A 529 plan is a state-sponsor plan that are designed to encourage saving for future college cost. All 50 states have their own 529 Plan. There are two types of 529 Plans and each state either has one or both types. The first type is called prepaid tuition plan. A prepaid tuition plan allows college savers to purchase units or credits at participating colleges and universities for future tuition, and in some cases room and board. In other words, you can lock in today's college tuition rates and the plan will pay for future college tuition at participating colleges and universities. Most prepaid tuition plan has residency requirements, meaning you have to live in that state to get that plan. In prepaid tuition plan, you need to put in one lump sum investment or with monthly installments. Investments in prepaid tuition plan are usually guaranteed a rate of return by the state. If you decide not to put in one lump sum or pay monthly installments, the plan will invest in mutual funds, which are not guaranteed.

The second type of the 529 Plan is the College Savings Plan. This type of plan generally allows the college saver (the account holder) to establish an account for the student (the beneficiary) for the purpose of paying the beneficiary's eligible college expenses. There are several investment options to choose from. Investment options often include stock (or equity) mutual funds, bond funds, money market funds, and age-based portfolios that automatically shifts to more conservative investments as the beneficiary gets closer to college age (which is usually 18 years old). This plan can be used with any college or university. Remember, mutual funds are not guaranteed a rate of return and are not FDIC insured.

Let's take a look at the benefits of the 529 Plan
1) Tax benefit. Any qualified withdrawal from the plan are tax-free. Qualified withdrawals are withdrawals that are used to pay for college tuition, room and board, textbooks, mandatory fees, and maybe a computer (if it is required by the school that students need it). In most states, earnings are tax-deferred. In some states, you may be allowed to make tax-deductions.
2) You have complete control of the account's assets. Unlike other education plans such as Coverdell or custodial accounts where the child can use it at age 18 or 21, the beneficiary does not gain control of the account no matter what age he/she becomes.
3) There are no restrictions on who you can open the account for. It can be your child, a relative, a friend, the mail man, or even yourself.
4) Since there are no restrictions, anyone can contribute to the account
5) No income restriction. It doesn't matter how much money you make, you can contribute!
6) Gift-tax exclusion. You can contribute up to $11,000/year or $22,000/year if you are married. (*Please note that this amount may change. Check for other sources to how much you can contribute tax-free.)
7) In most states, there are no age limit or time limit on when the money has to be used. If the child does not want to go to college, you can roll it over to another child in the same family.
8) In 529 College Savings Plan, the child can use the money for any college or university and maybe some international schools.
9) If your child gets a scholarship, the remaining balance in the plan can be rollover into another sibling or relative or it can be cashed out and you will just pay income tax on it.
10) Various investment options. Many states work with well known investment companies. There are many investment options to choose, but once you choose an option, you can't change it. You can roll it over to another state's 529 plan without any penalties if you are not happy with your investment option. You can only do this once every 12 months. Many plans offer age-based investments. That means your investments are invested in aggressive growth funds in early years to moderately aggressive growth in pre-teen years and finally in conservative funds (such as bonds and money market) in teenager years.

Let's take a look at some of the drawbacks of the plan:
1) If your child has a 529 plan, this may impact his/her ability to get financial aid.
2) Money in 529 plan can't be used as a collateral for a loan.
3) Any non-qualifed withdrawals will result in income tax and a 10% penalty tax. If the child receives a scholarship, you can withdraw money up to the amount in the scholarship and only pay income tax on it.
4) You don't control the investments since they are professionally managed by a portfolio manager.
5) You can only make cash contributions (by check or money order or direct debit).
6) Only one 529 plan per child.

Now that we establish the benefits and the drawbacks, its all up to you on which 529 plan to choose. I'm going to list some hints here to help you out.
1) Look at your state's 529 plan.
2) Check the manager of the plan. Look at investment company record of success.
3) Look at the fees the plan charges and the expense ratio.
4) Look at the maximum and minimum contribution limit.
5) Check if the plan offers any other benefits such as disability, terminal illness, or death.
6) Most of your questions can be answered in the prospectus.

To see the 529 Plan in your state, go here:

Common questions and answers:
Q1) What if my child doesn't want to go to college?
A1) You can let the account grow tax-deffered until he/she changes her mind. You can change the beneficiary to another child. You can withdraw the money, but you will pay income tax and a 10% penalty. People who usually don't go to college usually can't afford it. But I find out that most people who didn't go to college really wanted to go. Some people start college later in life. Even older people in their retirement has went to college. If money wasn't the issue, more people will be attending college.

Q2) There are so many 529 plans. Which one should I pick?
A2) Look at your state's 529 plan. Though, I personally like Colorado's Scholar Choice 529 Plan. Learn more about it here: Which one is best? Compare it with your state's 529 plan with the one I recommend.

Q3) Are contributions tax-deductible?
A3) Only some 529 plans allowed that and others say you have to live in that state in order to make tax deductions. So the answer is "only some of them."

To see other questions and answers, go to the Securities and Exchange commission website: