529 Plans A Tax-Smart Way to Save for College

Key Lesson: Q’s and A’s on 529 Plans

Despite recent proposals to scale back benefits, Section 529 plans remain a tax-favored way for parents to set aside funds for college. Here are the answers to several key questions on the subject:

Q. What exactly is a Section 529 plan?

A. It is a type of educational savings plan generally operated by individual states. If certain requirements are met, no tax is due on the accumulation of earnings or when funds are paid out for qualified expenses. There are two main types of Section 529 plans: the prepaid tuition plan and the college savings plan.

Q. How does a prepaid tuition plan work?

A. Essentially, the plan is guaranteed to keep pace with the rising cost of college tuition. For instance, let’s say it currently costs $15,000 annually to send a child to a state university. You pay $15,000 now to buy shares in a plan for a youngster. When the child is ready to go to college, your shares can pay for an entire year of tuition, no matter what it costs at that point.

This type of plan is often attractive to parents because it offers peace of mind. There’s no risk of loss of principal, and the investment is usually guaranteed by the state.

Q. How does a college savings plan work?

A. As opposed to a prepaid tuition plan, there is no guaranteed lock on future tuition costs under a college savings plan. In fact, the savings may not be enough to cover all of the costs. But there’s a bigger potential upside, because it’s possible to generate a better return with this type of plan. (Of course, there are no guarantees.)

Usually, the plan will offer an asset allocation strategy geared to the current age of the child or the year he or she will enter college. For example, the plan may provide more aggressive investments in the early years and switch over to more conservative investments as college approaches. Most college savings plans also offer a wide variety of risk-based asset allocation portfolios that are managed by professionals.

Q. What are the restrictions on contributions?

A. Anyone can contribute to a Section 529 plan on behalf of a named beneficiary. Each state is responsible for setting its own limits on the amount of contributions allowed to a college savings plan. Check the limits in the applicable state.

Under the annual gift-tax exclusion, you can contribute up to $14,000 in 2015 free of gift tax ($28,000 by a married couple). A special rule allows you to make five years’ worth of Section 529 contributions in one year.

Note: In the event a child decides not to attend college or attends college in another state, you may be able to transfer funds to another plan or “roll over” funds for the benefit of a successor beneficiary (e.g., a younger child).

Finally, realize that this type of plan is not for everyone. Investigate the options carefully to determine whether a Section 529 plan suits your family’s needs.

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