529 College Savings Plan Fully Explained!
By: Daniel'S Brew
Tags: Money, Finance, 529 College Savings Plans, Investing, College

Now that you know what a 529 is and what it’s purpose is, let’s talk about some of the unique features of this investment vehicle.

(1) First, there are no yearly contribution limits to a 529, unlike an IRA or HSA — that has specific yearly contribution amounts that you can’t exceed. But 529s usually have a total value cap for the account. So for a 529, you can contribute as much or as little as you want each year — but only up to the total account value limit, which is usually in the area of around $500k.

(2) Next, these plans, generally come in two different flavors — a pre-paid tuition plan, and an education savings plan.

A prepaid tuition plan works exactly like it sounds, it allows the account holder to purchase credits at participating schools, usually public colleges that are in-state, for future tuition and other fees involved with enrollment. The benefit of the pre-paid plan is that it allows you to purchase these credits at current prices — so that if the price of tuition rises later on, you would have paid a much cheaper amount for that same credit.

The only downsides to this approach is that you can’t invest your money because it’s not put into an investment account, rather they are stored as purchased tuition credits, at a particular university and for this method you have to select and be locked into the school you chose from the beginning — as these credits are generally not transferable to any other school.

But if you look back at history, the prices of tuition nationally have gone up over 25% in the last 10 years. So if you’re certain about what school your beneficiary wants to go to in the future, pre-paying for tuition credits can be a pretty smart move.

Credit: CNBC Make It

The 2nd 529 flavor is the Education Savings route and in this method, the account holder opens an investment account and saves for the beneficiary’s qualified education expenses in the future — much like an IRA or HSA.

And from a tax viewpoint, the 529 is a double tax advantaged account — where you contribute after-tax dollars, and it grows within the account tax free and withdrawals from the account are also tax free, as long as it’s for qualified educational expenses.

(3) The third thing to note about this program, is that there is no one national plan because 529s are all state sponsored, meaning each state has and runs their own program.

Now, this is really important to understand — because for a prepaid tuition program, while you can choose ANY state’s plan, this means that you have to pick a specific school to contribute to and when you are ready to reap the benefits of your contributions, I.E. use the tuition credits — you can only use it for that particular school.

And in the pre-paid tuition route, when it comes time for you to use the funds, some programs actually require you to be a resident of that state — which means you would likely have to move there if you opened up a pre-paid 529 plan in any other state besides the one you are currently residing in.

Far more flexible, is the education savings plan.

In this one, you can contribute to any state program and withdrawal to use the funds for any other state educational expense, regardless of where you live. So as an example, you could be a resident of say, Texas, and set up a 529 in California, or be a resident of Michigan and open an account in Alabama and in either of those cases, make a withdrawal and pay for tuition in New York, if that’s where your beneficiary decided to go.

Credit: Daniel’s Brew

So then, an obvious question you’ll want to ask is, “If in the education savings plan, I can use the funds for any state school my beneficiary wants, does it matter at all, which state program I initially sign up for and participate in?”

Well, the answer is Yes — and here’s why.

There are 2 main considerations to make when choosing the right state sponsored education savings plan.

1) The first is — Local Tax Consideration. You see, if you live in a state that has state income tax, most of those states offer some type of local state tax deductions for contributing to a 529 program. In this case, your contributions would be partially tax free because of this deduction benefit. But one thing you have to watch out for, is that certain states may require you to then use the funds within their state, or pay back some of the tax deduction amount later in distribution. So you’ll want to make sure you check with the fine print before going with your state’s 529 plan, if you’re in it for the upfront tax savings.

2) The second consideration is Investment Choice and Account Performance. Each state’s 529 is powered on the backend, by a certain brokerage or financial planning firm that the program has a partnership with. And through that partnership, there are usually a specific set of investment options that are uniquely provided for that program. And these choices are typically objective or risk based portfolios that they create and manage on your behalf. These portfolios usually have a collection of underlying mutual funds or bond funds and their mix is determined by the portfolio strategy.

Here is an example of some investment choices with New York’s 529 program.

Source: NYsaves.org

As you can see, it looks like this program partnered with Vanguard for their investment vehicles and they seem to offer a good mix of growth and balanced investment strategies in their offerings.

One thing to remember, is that because you don’t have much say in what the underlying funds are within your portfolio (since it’s managed by the program itself), it’s important to make sure you look at the performance of these funds over time, before you commit to a particular state’s program. There is usually a historical performance section in most 529 websites where you can compare how each portfolio does against their underlying benchmark. And if you do some research, you’d be surprised at how much of a difference the portfolio’s performance can be across different state programs.

So make sure you invest a little time to do some comparisons between state 529s — before you commit to one.