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What is 529 Plan?

A 529 plan is a tax-advantaged college savings plan created to encourage saving for future education expenses. There are two types of 529 plans: pre-paid tuition plans and college savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a pre-paid tuition plan.

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

College savings plans generally permit an account holder to establish an account for a student (the "beneficiary") for the purpose of paying his or her eligible college expenses. An account holder may typically choose among several investment options, which the college savings plan invests on behalf of the account holder. Investment options typically include stock mutual funds, bond mutual funds, and money market funds, as well as, age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any qualified college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.

Investing in a 529 plan may offer college savers special tax benefits. Earnings in 529 plans are not subject to federal tax, and in most cases, state tax, so long as you use withdrawals for eligible college expenses, such as tuition and room and board.

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% federal tax penalty on earnings. Many states offer state income tax or other benefits, such as matching grants, for investing in a 529 plan. But you may only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence. Just a few states allow residents to deduct contributions to any 529 plan from state income tax returns.

Fees and expenses vary based on the type of plan selected. Prepaid tuition plans typically charge enrollment and administrative fees. In addition to "loads" for broker-sold plans, college savings plans may charge enrollment fees, annual maintenance fees, and asset management fees. Some of these fees are collected by the state sponsor, and some are collected by the financial services firms that manage the 529 program.

While each college or university may treat assets held in a 529 plan differently, investing in a 529 plan will generally reduce a student's eligibility to participate in need-based financial aid.

Parents should also consider other tax-advantaged ways to save for college include Coverdell education savings accounts, juvenile life insurance, tax-exempt municipal securities, and savings bonds.