All About 529 Plans
Qualified tuition plans, also known as 529 plans, have changed the college savings playing ground. These state-sponsored plans serve up big tax advantages, making it easier than ever to save for a college education. There are two main types of 529 plans: college savings plans (the type most people think of when they hear 529) and prepaid tuition plans.
If you use the money from a college savings plan on expenses that don't qualify, you'll be subject to a hefty tax penalty on your earnings: an extra 10 percent on top of the normal taxes that will be due. For example, transportation to the school and dorm room decorating items do not qualify as education expenses.
College savings plans allow an account holder (usually a parent or grandparent) to set up an account for a future student (formally called the beneficiary). As the account holder, you make decisions about the account, which can include investment choices, though these may be limited depending on the state sponsoring the plan. When it's college time, you can use the funds in this 529 plan to pay for all “qualified higher education costs,” which include fees, books, and computers along with tuition and room and board. And as long as you use the money for such qualified expenses, you won't have to pay federal income taxes; in most cases, the funds will be exempt from state income taxes, too. In fact, many states give their residents a current tax deduction for contributions to the home state 529 plan; some states even give you a deduction if you contribute to any state's plan.
Another huge advantage of these plans is the enormous contribution limit. You can get these tax-advantaged savings on contributions as large as $300,000 in some states. Plus, there are no income limitations, meaning you can't get phased out of the tax benefits on these plans. Of course, there's still a little tax catch (there always is): The contributions could be subject to federal (and possibly state) gift taxes. As of the date of this printing, gifts larger than $12,000 (or $24,000 from a couple) are typically subject to gift tax reporting. Luckily, there's a special exception that specifically addresses 529 plan contributions: a couple can put up to $100,000 into a qualified state tuition plan and it will count as $20,000 over five years, nullifying the whole gift tax issue. But they can't make any more gift-tax-free contributions until that five years is up.
It all sounds good, but there are some disadvantages. For example, you have limited control over where your money gets invested. Typically, the state invests the funds for you from a very limited menu. In some states, you may have as few as two investment choices, up to thirty in others. Plus, you can only change your choices once a year. Also, funds in a 529 plan account do reduce the amount of financial aid available to the student.