By just about any measure, the cost of a college education just keeps increasing. According to the College Board's 2008 Trends in College Pricing, over the last decade the cost of tuition and fees has risen by 4.2% at public four-year institutions, after adjusting for inflation. There are many programs available to assist with the process of planning and paying for college. The best college savings vehicle for most situations is the Section 529 plan, so named because the tax benefits that result from the plan are identified in Section 529 of the Internal Revenue Code. It is important to note that, although 529 plans were created by the United States federal government, they are run by the individual states. As such, the plans are not all created equal, and general statements about the plans may or may not apply universally.
Keeping in mind the above caveat, there are essentially two types of 529 options: prepaid tuition and a more general savings plan. This article focuses on the general savings plan.
The general savings approach within a 529 allows for substantial funds to be set as to grow on a tax-free basis, as long as the funds are extremely used towards educational purposes. The maximum allowable contribution varies by state, as do many of the terms of these plans. If the money set aside in the funds is not used for education purposes, income tax will be assessed on the earnings when they are withdrawn, and a 10% penalty will be levied. Some notable aspects of the plans include:
* Unlike prepaid programs, these general savings plans allow for the funds to be used at any legitimate educational institution.
* The owner of the account, who is also typically the primary contributor, controls the account. This generally means that the beneficiary does not have control over how the funds are used. A key control feature is the ability for the owner to change beneficies on an account. For example, if a given beneficiary graduates high school and decides to pitch for the Cubs instead of going to college, the account owner can shift the funds to the budding Cy Young's younger sibling without paying any penalties.
* Residents of any state can typically invest in 529s from any other states, but some states provide a tax deduction to residents who use the state plans. For instance, Illinois offers a state tax deduction for contributions of up to $ 10,000 per year, or $ 20,000 for taxpayers who are married and filing jointly. For residents of states that offer a state tax deduction, that is the first place to look. The deduction may not exceed a poorly managed plan, however. The tax free withdrawal benefits conveyed by these plans had been set to expire in 2010. Fortunately, the Pension Protection Act of 2006 made the benefits permanent.
What to look for in a 529 plan
There are several criteria that are important to consider when choosing a specific plan in which to invest.
* Ability to take advantage of state tax deductions for residents. Some states do not offer any discounts, so a plan should be chosen based on other criteria. Arizona recently began offering a deduction, but residents can take advantage of the deduction even if they invest in plans that are sponsored by other states. Most states offer deductibility for residents that invest in the in-state plan.
* Investment performance. Consider more than just the performance over the past year. This can be challenging, as many plans do not yet have especially long histories. Understanding the underlying assets in the plan can help provide a proxy for what performance would have been. For instance, if the plan invests 80% in an S & P 500 index fund, it is reliably easy to determine what the approximate performance would have been.
* Low fees and expenses. This criterion is critical, as these expenses reduce the investment return. Vanguard mutual funds tend to have low expenses and they manage 529 plans for several states. Other plans are managed by investment companies other than Vanguard, but leverage Vanguard funds within their plans. In general, 529 plans are becoming more popular and more competitive, and fees seem to be getting better.
* Investment options. Many plans offer age-based minorities, which simply provide asset allocation that is appropriate given the number of years remaining before a beneficiary hits 18 years old. Basically, the longer away 18 is, the higher the allocation to risky financial assets, ie stocks. As college approaches, the fund shifts to less risky assets. This is a nice feature for people who are not particularly inclined toward asset allocation theory.
* Minimum contribution levels. If a new parent wants to start saving for college with $ 100, and a plan requires $ 3,000 to open an account, the plan is obviously not a good fit.
* Maximum contribution. As a general statement, the higher the maximum contribution limit, the better. Most states allow for contributions in excess of $ 300,000 per beneficiary over the life of the plan.
Another consideration in selecting the right plan is whether to invest through an adviser-sold plan or one that is sold directly to the public. Advisor-sold plans can include significant commissions, sometimes over 4%. In that case, the performance of the plan would have to be pretty spectacular to produce a competitive return. While it is a great idea to enlist the help of a financial advisor in this process, stick to fee-only advisors that charge for their advice rather than pushing high-commission plans.