What You Need to Know About 529 Plans

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Published May 16, 2014

| Bankrate.com

One of the most popular college savings vehicles -- with good reason -- is the 529 plan.

Offering federal and, in some cases, state tax advantages, 529 plans are low maintenance, provide tax-deferred growth and make less of an impact on a student's financial aid package than assets stored in checking and savings accounts.

These plans are also complex, and choosing the one that fits your family can be difficult. Know these seven things before opening a 529.

Some are pricier than others

According to the U.S. Securities and Exchange Commission, 529 plans come in two flavors. First, there are prepaid plans that allow families to buy "units" of tuition at a rate close to today's prices. They are cashed in when the student attends school. Second, there are 529 college savings plans that allow families to invest in preselected investment portfolios that grow (or shrink) in accordance with the markets. Many states and the District of Columbia offer 529 college savings plans, according to Morningstar, an independent investment research company. But only a handful of states offer a prepaid option.

Both types of plans come with annual fees and operating costs. For college savings accounts, average expense ratios range from about 0.13% to 1.88% of invested assets, according to a 2013 Morningstar survey.

One of the major factors that drives costs up is whether a 529 plan is broker-sold and overseen by a financial professional or direct-sold, wherein plan holders manage their own assets.

"The broker-sold adviser plans, there's a higher expense structure to those plans, but what you do get for those higher costs are the advice of the financial professionals you're working with," says Paul Paeglis, executive director of the Ohio Tuition Trust Authority, which oversees that state's 529 plan.

There's risk involved

Many 529 college savings plans contain mutual funds that are tied to the stock and bond markets, meaning families can potentially lose money if their investments take a hit.

"The question you have to ask yourself is: 'How diversified is the 529 itself?'" says Sam Mikhail, president of College Planning Advisors, a college planning firm in Burbank, California.

When deciding on the right college savings plan, Mikhail advises families to evaluate whether a 529 plan is the best bet, then examine the underlying funds in a particular plan and investigate each fund's historical performance. There are generally several investment options for you to choose from in 529 plans.

Families may also want to check out the growing number of no-risk 529 plan options. Several states like Arizona and Montana have FDIC-insured CDs and savings options that provide families with 529 tax benefits without the risk (or growth) associated with market fluctuations.

They might not keep up with your kid

Among the most popular 529 college savings options are age-based, target-date funds that automatically shift from aggressive to conservative investments as the child approaches college age. Stuart Ritter, vice president and CFP with T. Rowe Price Investment Services, advises families eyeing age-based portfolios to examine how they change over time.

"It's important to understand what the investments are, and make sure that how your money is allocated between stocks, bonds and short-term investments is appropriate for the time horizon you're looking at," Ritter says.

How fast investments shift varies among 529 plans. To ensure your age-based portfolio is keeping up with your savings needs, Ritter advises families to evaluate several age-based portfolios before choosing one and to periodically re-evaluate how their 529 plan is evolving. If a plan isn't changing according to your needs, the IRS allows families to change portfolios once per year.

Your state's plan may not offer the best deal

While all 529 plans come with federal tax advantages, certain states also offer state income tax deductions or credits, too. These can be substantial.

Indiana, for example, offers a tax credit of up to $1,000 per year. Meanwhile, New York and Oklahoma offer annual tax deductions of up to $5,000 and $10,000, respectively, for single filers. The limits double for married couples filing jointly.

A few states, such as North Dakota, sweeten the deal even more by offering matching grant programs that match a certain amount of a family's contributions. Eligibility requirements for tax advantages and matching grants vary by state.

While these incentives can provide an extra push to invest close to home, families should still compare different plans and evaluate whether tax incentives are enough to make a home state's plan the best financial bet, says Deborah Goodkin, managing director of college savings plans at First National Bank of Omaha, the entity that oversees Nebraska's 529s.

"If (a 529 plan offers) tax advantages, it may or may not be the best reason to invest in your home state's plan," she says. "That's up to the investor and their financial adviser."

Independent investors may want to take a close look at fees, which can make a big dent on investment returns.

Most prepaid plans aren't guaranteed

Prepaid 529 plans aren't subject to market ups and downs, but they're not always a sure thing either.

"There are not a lot of states that even offer prepaid plans anymore, and the level of guarantee amongst those states definitely varies," Paeglis says.

Among prepaid 529s, only a scant few, such as Washington's Guaranteed Education Tuition program, come with a legally binding promise the state will pick up the tab if the plan folds between the time parents open the account and Junior goes off to school. Families eyeing prepaid plans are encouraged to inquire about a state-backed guarantee before opening an account, to research the plan's historic performance and stability and to ask what happens if tuition prices sharply increase.

529s impact financial aid

It's true 529 plans will factor into how much financial aid a student may qualify for, but it shouldn't be a deal breaker.

"People think if I have $100 saved in a 529 plan, that means I'm getting $100 less in financial aid. That is wrong," says Ritter. "About 5.6% of a parent's assets are expected to be used for college. That means for every $100 that the parent has saved, their financial aid would be reduced $5.60."

Money stored in a 529 plan will impact your federal financial aid package, but not as much as funds stored in some other types of accounts. The Department of Education reports that every dollar stored in a 529 account in a parent's name will subtract up to 5.6 cents from your family's federal need-based financial aid package. By contrast, funds stored in checking and savings accounts in a child's name will subtract up to 20 cents per dollar from federal financial aid, whereas funds kept in an individual retirement account in either the parent or child's name won't be considered at all until the family begins taking withdrawals, at which point those funds would be considered untaxed income and could make a drastic impact on financial aid.

Relatives can help (and also hurt)

One way to get around the federal financial aid assessment is to store 529 cash in an account held in a relative's name. Accounts held by family, friends and relatives for 529 plans will be sheltered from the federal financial aid needs analysis, reports Finaid.org. The needs analysis is the primary formula used to determine financial aid at public colleges and universities. However, those funds will still be factored in for students attending private colleges that use the CSS Profile needs analysis formula.

Even if the money is sheltered, it's only temporary, reports the Department of Education. Once students begin taking withdrawals from 529 accounts held in relatives' names, the funds count as income and can subtract up to 50 cents in federal aid for every dollar withdrawn. To get maximum federal aid and minimal 529 impact, families can hold off on taking 529 withdrawals from relatives until after the student has received financial aid for their last year of school.

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