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Saving for College

If you are like most Americans with children, how you will pay for your child's college education is never far from your mind, even if your child is still just a toddler. With tuition costs increasing each year, it is never too early to start planning. One way to start saving is through an IRC Section 529 College Savings Plan.

What is a Section 529 Plan?

The Section 529 Plan is an investment savings plan operated by individual states to help families save for their child's future higher education expenses. Each state operates its own Section 529 Plan with different requirements, guidelines, and benefits.

There are two general types of Section 529 Plans, savings plans and prepaid tuition plans. The savings plans offer dedicated qualified state college savings accounts which provide families a variable rate of return, but are not guaranteed to keep pace with tuition inflation. The prepaid tuition plans offer families an option to prepay tuition based on today's costs of college tuition and provide a guarantee to keep pace with tuition inflation.

Savings plans allow a person (the "owner") to set up a Section 529 Plan for a beneficiary and to contribute money to the account. When the beneficiary starts college, the beneficiary can take out funds to pay for qualified higher education expenses. Higher education is defined broadly and encompasses accredited colleges and universities, as well as vocational schools. The plans generally invest in mutual funds from well-known companies, such as Fidelity, Vanguard, and TIAA-CREF.

Prepaid tuition plans, also known as tuition account programs, are college savings plans that are guaranteed to increase in value at the same rate as college tuition. Any interested party can lock into today's tuition rates by purchasing shares worth future tuition at one of the state's public colleges or universities. If shares worth a semester's tuition at a state college are purchased, those shares will always be worth a semester's tuition. The program will pay out the future tuition at any of the specific state's eligible colleges or universities. However, not all states extend the plan to in-state private schools. In addition, if the beneficiary decides to attend a non-participating or out-of-state school, the program may only refund what was original contributed. Interest may be eliminated or a cancellation penalty may be applied.

Because of the flexibility inherent in the savings plan, most parents will choose the savings plan over the prepaid tuition plan. Indiana offers only a savings plan. Money saved in the Indiana Family College Savings Plan can be used at accredited public and private colleges in Indiana or out-of-state.

Indiana, as well as many other states, offers two types of investment options under the savings plan. The first is based on the age of the beneficiary. When the beneficiary is young, the investments are more aggressive. The investments gradually become less aggressive as the beneficiary nears college age. Under the second option, the owner chooses from different investment options, allocates different percentages between the investments, and can change future investment percentages periodically.

Most states do not have a residency requirement for setting up a Section 529 Account, and contributions can be made as often as desired. Each state's plan has different requirements and options, so it is important to research the various options. The Internet is a good place to start.

In Indiana, a person can start a Section 529 Account with as little as $60.00, which consists of a $10 initial enrollment fee and $50.00 for the minimum initial contribution. Subsequent contributions must be at least $25.00, and contributions can be made as often or as infrequently as desired. Once the account has been established, any person can contribute to a beneficiary's Section 529 Account, as long as he or she has a payment/contribution coupon which can be obtained from the person who set up the account.

Advantages of a Section 529 Plan

There are many advantages to be gained from investing in a Section 529 Plan, including the following:

Qualified withdrawals after 1/1/2002 are tax exempt for federal income tax purposes.
Qualified withdrawals after 1/1/2002 from the Indiana Plan are tax exempt for Indiana income tax purposes (if the account is an Indiana plan account).
The owner of the account maintains control. The owner is generally a parent or a grandparent.
The owner can change beneficiaries on the account if, for example, the original beneficiary does not use the funds for any reason.
The owner can even withdraw the money (subject to income taxes and a penalty).
Anyone can contribute. There are no income tax limits.

Disadvantages of a Section 529 Plan.

With any plan, there are some disadvantages, including the following:

Limits on how long a plan account can be open. For example, the Indiana Plan only allows the plan account to be open for 25 years.
Negative impact on eligibility for federal student aid. Every dollar saved in a prepaid tuition plan reduces eligibility for federal student aid by a dollar.
Penalty on earnings if funds are withdrawn for non-qualified reasons.
Tax on earnings if funds are withdrawn for non-qualified reasons.
Possible cancellation fee may apply if funds are withdrawn for non-qualified reasons.

What if my child does not go to college?

Federal law requires that the owner or the beneficiary of the account (the person making the withdrawal) be assessed a 10% penalty for all non-qualified withdrawals. However, there are exceptions to the penalty requirement, such as if the beneficiary has received a scholarship. Some plans are transferable between siblings and other related individuals.

Gift and Estate Tax Considerations

If a person wishes to contribute money to a beneficiary's Section 529 Account, the gift should not exceed the annual gift tax exclusion of $10,000.00 per calendar year. However, the law allows an individual to make a contribution of up to $50,000 and to treat the contribution as made over a five (5) calendar year period to avoid the filing and paying of gift taxes.

Carefully evaluate your options before investing in a Section 529 Plan. Choose the plan that best meets your investment goals and the anticipated college objectives and needs of the beneficiary.