Saving For College? These Plans Make The Grade

By Brian Mulford

Spring 2006

If you are looking for a way to save for a child's college education, consider investing in a 529 plan, a tax-advantaged savings plan designed to encourage saving for future college costs. Authorized by Section 529 of the Internal Revenue Code, these "qualified tuition plans" are sponsored by states, state agencies and educational institutions.

There are two types of 529 plans: pre-paid tuition plans and college savings plans. All 50 states and the District of Columbia sponsor at least one type of 529 plan.

Pre-paid tuition plans generally allow college savers to purchase units or credits at participating colleges for future tuition and, in some cases, room and board. Most pre-paid tuition plans are sponsored by state governments and have residency requirements.

College savings plans permit an account holder to save for a student beneficiary's eligible college expenses, and withdrawals from these plans typically may be used at any college.

"Investment options for college savings plans often include stock mutual funds, bond mutual funds and money market funds, in addition to age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age," says Susan Ferris Wyderko, Director of the Office of Investor Education and Assistance at the U.S. Securities and Exchange Commission (www.sec.gov/investor.shtml).

Tax Considerations

Investing in a 529 plan may offer college savers special tax benefits. Earnings are not subject to federal tax or (in most cases) state tax, as long as you use withdrawals for eligible college expenses.

However, if you withdraw money from a 529 plan and do not use it on an eligible college expense, you generally will be subject to income tax and an additional 10 percent federal tax penalty on earnings. In addition, unless current tax legislation is extended or modified, many of the federal tax benefits of 529 plans will expire December 31, 2010.

"Some states also allow residents to deduct contributions to 529 plans from income tax returns for the state that sponsors the plan, but this benefit likely will be available only if you participate in a 529 plan sponsored by the state that you treat as your state of residence for income tax purposes," says Wyderko. "Some states also offer matching grants or other additional benefits, typically to low-income investors."

Fees And Financial Aid

Fees and expenses will vary based on the type of plan. Prepaid tuition plans typically charge enrollment and administrative fees. Direct-sold college savings plans may charge enrollment fees, annual maintenance fees and asset management fees. Your asset management fees will depend on the investment option you select. Each investment option usually will bear a portfolio-weighted average of the fees and expenses of the mutual funds and other investments in which it invests.

You generally will pay additional fees if you invest in a broker-sold plan. Depending on the share class you buy, you may pay a "load," or sales fee, and annual distribution fees of between 0.25 and 1.0 percent of your investment. All or most of these fees are paid to your broker for selling the plan to you.

Investing in a 529 plan generally will reduce a student's eligibility to participate in need-based financial aid. Beginning July 1, 2006, assets held in pre-paid tuition plans and college savings plans will be treated similarly for federal financial aid purposes. Previously, assets held in college savings plans received more favorable financial aid treatment.

The Big Picture

Before you start saving specifically for college, consider your overall financial situation. Instead of saving for college, you may want to focus on other financial goals such as buying a home, saving for retirement or paying off high-interest credit card bills. Keep in mind that you may face penalties or lose benefits if you do not use the money from a 529 account for higher education expenses.

"The best way to make an informed decision about any college savings plan is to understand its terms," says Wyderko. "Read the plan's disclosure documents."

Most 529 plans post their disclosure documents, sometimes called offering circulars or program descriptions, on publicly available websites. The College Savings Plan Network provides links to most 529 plan websites.

Remember that there are many 529 plans out there and other options for saving for college. If you need help determining which option works best for your circumstances, consult your financial advisor, tax advisor, or broker before you start saving.

# # #

Brian Mulford is an attorney in the Office of Investor Education and Assistance at the U.S. Securities and Exchange Commission. The SEC disclaims responsibility for any private publication or statement of any employee or Commissioner. This article expresses the author's view and does not necessarily reflect those of the SEC, the Commissioners or other members of the staff.

# # #

On The Move Or Settling In?

Whether you're a new plan investor or a new resident, consider whether investing in a 529 plan sponsored by your home state is best for you:

Does my home state's plan offer tax advantages or other benefits?
Do the tax advantages or other benefits offered by my state outweigh the benefit of investing in another state's less expensive plan?
What happens if I change my state of residence?
Will I pay recapture penalties for rolling money out of my home state's plan into another plan?

# # #

Don't Pay Too Much

Here are a few ways you can invest in a 529 plan and reduce or avoid some fees and expenses.

Invest in a Direct-Sold Plan. Every state offers a college savings plan in which residents and, in many cases, non-residents can invest without paying a "load," or sales fee. This type of plan, which you can buy directly from the plan's sponsor or program manager without the assistance of a broker, generally is less expensive because it waives or does not charge sales fees that may apply to broker-sold plans.

Make Regular Contributions. Some college savings plans will waive or reduce some of your fees if you participate in an automatic contribution plan.

Consider Your Home State's Plan. If you are a resident of a state sponsoring the 529 plan, you may pay lower fees than non-residents. In addition, you may receive state tax benefits for investing in your home state's plan.

Get a Breakpoint Discount: If you purchase a broker-sold college savings plan, you may be able to reduce sales fees if you invest or plan to invest above certain threshold amounts. These "breakpoint discounts" apply only to Class A shares, which charge an up-front sales fee when you invest in your plan. Even if you qualify for a breakpoint discount, you likely will pay lower fees and expenses by investing in a direct-sold plan.

# # #

Related articles:

Start Saving For Your Baby's Education - Now!
Help Your Children Reach Financial Independence
Start Now, Save Big On College Financing

« click here for more Investing