529 Plans (Qualified Tuition Programs)

• Introduction
• State savings plans
• Prepaid tuition plans
• Selecting a specific 529 plan
• Managing your 529 account
• Financial aid and 529 plans
• Questions & Answers

Introduction
Since their introduction a few years ago, Section 529 plans are revolutionizing the way parents,
grandparents, and others save for college. Americans are pouring billions of dollars into 529 plans,
and contributions are expected to increase dramatically in the coming decade. What makes these
plans so special? The primary advantage of 529 plans is that funds in the plan are free from income
tax at the federal level when used to pay the beneficiary's qualified education expenses. Plus,
anyone can open a 529 account, regardless of income level or state of residence.

There are two types of 529 plans−−state savings plans and prepaid tuition plans. Each works
differently, and it's important to understand these differences before you open an account in a 529
plan.

Caution: This discussion refers to provisions of the Economic Growth and Tax Relief
Reconciliation Act of 2001, which made qualified withdrawals from a 529 plan tax
free at the federal level. These provisions are schedule to expire on December 31,
2010. Unless Congress extends the law, after December 31, 2010 the federal tax
treatment of 529 plans will revert to its status prior to January 1, 2002.

Caution: Fees and expenses are typically associated with opening and/or
maintaining a 529 account (e.g., annual maintenance and administration fees, and
investment expenses based on a percentage of your total account value)

State savings plans

A state savings plan lets you save money for college in an income tax−deferred investment
account. The account is managed by an experienced financial institution designated by the state.
When you open an account, you name your child (or grandchild or other friend or relative, as the
case may be) as beneficiary. You also choose or are assigned an investment portfolio for the
investment of your contributions. Each portfolio typically consists of various mutual funds. You then
contribute as much or as little money as you like, subject to the plan's limits.

For more information, see the discussion 529 State Savings Plans .

Prepaid tuition plans

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 A prepaid tuition plan lets you prepay tuition expenses at participating colleges for use in the future,
allowing you to lock in current tuition costs and gain some peace of mind over spiraling college
costs. There are two types of prepaid tuition plans−−the original prepaid tuition plans, which are
offered by states, and the newer college prepaid tuition plans, which have been offered by colleges
since 2002. Generally, state prepaid tuition plans are open only to state residents, while college
prepaid tuition plans are open to everyone. Note: Unless specifically noted, all references are to
state prepaid tuition plans.

For more information, see the discussion 529 Prepaid Tuition Plans .

Selecting a specific 529 plan

There are many factors you should consider when deciding between a state savings plan and a
prepaid tuition plan. In the case of state savings plans (which generally allow nonresidents to join),
you should compare several characteristics that can make these plans differ from state to state. For
example, investment options and flexibility, fees, state tax treatment, and contribution rules can vary
widely.

For more information, see the discussion Choosing a 529 Plan .

Managing your 529 account

Once you select a particular 529 plan and open an account, you'll need to understand your plan's
rules about plan contributions and, later, plan withdrawals. Though most plans operate under the
same federal guidelines, there is room for innovation within individual plans. You may also want to
understand if it's better to make lump−sum or periodic contributions, and learn about ways to
maximize your contributions.

For more information, see the discussion Making Contributions and Withdrawals to Your 529
Account .

Financial aid and 529 plans

At college time, your 529 plan will impact the financial aid process because it's a countable asset.
In other words, the value of your 529 account will affect how much financial aid your child may
receive. The federal government treats state savings plans and prepaid tuition plans differently,
while colleges generally treat these plans the same.

For more information, see the discussion 529 Plans and Financial Aid .

Questions & Answers

Why are these plans referred to as "529" plans?

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 State savings plans and prepaid tuition plans are often referred to as 529 plans because they are
governed by Section 529 of the Internal Revenue Code. Specifically, in order for these plans to gain
favorable federal tax treatment, they must comply with all provisions of Section 529 of the tax code.
Under federal law, 529 plans are officially called qualified tuition programs, or QTPs.

Tip: In many instances, the term "529 plan" is used interchangeably with "state
savings plan," but this use is not completely accurate. A state savings plan is only
one type of 529 plan; a qualifying prepaid tuition plan is the other.

How long have 529 plans been around?

Section 529 plans were created by the federal government with passage of the Small Business Job
Protection Act of 1996, a piece of legislation that actually had little to do with college savings. These
plans were later modified by the Taxpayer Relief Act of 1997 and the Economic Growth and Tax
Relief Reconciliation Act of 2001. Under the most recent law, 529 plans are officially referred to as
QTPs.

How many states currently have 529 plans?

All 50 states offer state savings plans. Some states also offer prepaid tuition plans.

Who can legally offer 529 plans?

It depends on the type of 529 plan. There are two types of 529 plans−−state savings plans and
prepaid tuition plans. With state savings plans, only states are allowed to operate them. With
prepaid tuition plans, both states and colleges are allowed to operate them. (Note: Though colleges
have been allowed to operate their own prepaid tuition plans since 2002, qualified withdrawals from
such plans won't be free from income tax at the federal level until 2004.) To gain favorable federal
tax treatment, any state savings plan or prepaid tuition plan must meet all of the requirements of
Section 529 of the Internal Revenue Code.

Tip: As a practical matter, states designate an agent (usually a financial institution or

other professional money manager) to manage and administer their particular state
savings plan or prepaid tuition plan.

How much can you invest in a 529 plan?

Section 529 of the tax code requires that a 529 account not accept more contributions than are
necessary to meet the expected qualified education expenses of the account beneficiary. A plan will
pass this test if it limits total contributions to the amount needed to fund five years of the
beneficiary's tuition, fees, and room and board at the most costly college allowed under the
program. Each plan can set its own limit within this guideline. When the value of a beneficiary's
account reaches the limit chosen by the state, no more contributions may be made to that state's
529 plan for the beneficiary. (Some states may also impose an annual contribution limit.) In the
majority of states, the maximum contribution limit is at least $250,000.

Keep in mind that the contribution limit for a 529 plan is a per−beneficiary limit. For example, you,
your father, and your sister each open a 529 account in the same state's plan for the benefit of your

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son. The plan has a lifetime contribution limit of $230,000, but that doesn't mean that you can each
contribute $230,000. Instead, none of you may contribute after the aggregate value of your son's
accounts reaches $230,000. This per−beneficiary limit can work in your favor if you have more than
one child who will be attending college. Using the same $230,000 limit, if you have four children,
you could set up a separate 529 account for each child and invest up to $230,000 in each account
(a total of $920,000 for the four children).

Another thing to keep in mind is that plans periodically raise their contribution limit to keep pace
with rising college costs. If this is the case with your plan, make sure that you can keep contributing
as the limit increases.

Is your rate of return guaranteed under a 529 plan?

That depends on the type of 529 plan−−a state savings plan or a prepaid tuition plan. Think of a
state savings plan as a mutual fund run by a state. The state or its agent invests your contributions
in one of several pre−established investment portfolios. These portfolios are either age−based or
not age−based. If the portfolio is age−based, the investments in the portfolio will be growth−oriented
when the beneficiary is younger, and the state will automatically shift money into more conservative
investments as the beneficiary approaches college age. If the portfolio is not age−based, the types
of investments (e.g., growth, balanced, conservative) will stay the same as the beneficiary grows
older. Although you can potentially earn a higher rate of return with state savings plans, the rate of
return is not guaranteed, and there's a chance you could lose money.

Prepaid tuition plans, though, generally guarantee you a minimum rate of return to ensure that you
keep pace with college inflation. In effect, you lock in tomorrow's tuition at today's prices. However,
you'll generally be limited to the rate of return promised by your plan−−you won't be entitled to any
excess investment gains.

Will you pay income tax when the money in your 529 plan is withdrawn to pay for college
expenses?

Section 529 plans include state savings plans and prepaid tuition plans. You will not pay federal
income taxes on distributions from a state savings plan that you use to pay qualified education
expenses. (Distributions include both your original contributions plus the earnings or growth.)
Qualified education expenses may include tuition, fees, books, and room and board for college and
graduate school.

Distributions from state−sponsored prepaid tuition plans are treated in the same way−−distributions
that you use for qualified education expenses will also be nontaxable on your federal income tax
return. Tax treatment may differ, though, if you participate in a prepaid tuition plan sponsored by an
educational institution rather than by a state. In 2002 and 2003, any earnings distributed by such a
plan will be taxed at the federal level. But starting in 2004, earnings will be free from income tax at
the federal level if used to pay qualified education expenses.

Although qualified distributions won't be taxed on your federal income tax return, state income tax
treatment may differ; check the laws of your state. Also, keep in mind that federal income tax
treatment of 529 plans may change after 2010 unless the present law is extended by a future
Congress.

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Will you be penalized if the money in your 529 plan isn't used for college expenses?

Whether your 529 plan is a state savings plan or a prepaid tuition plan, you avoid federal income
tax and a penalty only if the money you withdraw is used for the beneficiary's qualified education
expenses. These expenses include tuition, fees, books, and, if the beneficiary is attending school at
least half−time, room and board for college and graduate school.

If you use the money for any other purpose, the earnings portion of the distribution will be taxable
on your federal (and possibly state) income tax return in the year of the distribution. Also, you
generally must pay a 10 percent federal penalty on the earnings portion of your distribution. (There
are a couple of exceptions. The penalty is usually not charged if you terminate the account because
your beneficiary has died or become disabled, or if you withdraw funds not needed for college
because your beneficiary has received a scholarship.)

Bear in mind that the "distributee" is the one subject to tax. (The distributee is the person who
actually receives the money from the 529 plan.) In most situations, this will be the account owner.
So, if you fund a state savings plan for your son, for example, and withdraw the money three years
later (before he reaches college age), you will probably be the one taxed and penalized. However,
some plans specify who the distributee is, while others allow the account owner to determine the
recipient of a nonqualified withdrawal.

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