529 College Saving Plans

529 college savings plans, also known as 529 plans, are tax-advantaged methods of saving for college. Earnings accumulate on a tax-deferred basis. The earnings portion of a non-qualified distribution is taxed at the beneficiary’s rate, plus a 10% tax penalty. Qualified distributions are entirely tax-free. Contributions to the state’s 529 plan may be eligible for a state income tax deduction or tax credit, depending on the state.

Contributions

Contributions to a 529 college savings plan are made with after-tax dollars. There is no requirement that the donation come out of earned income. Contributions must be made in cash or a cash equivalent.

There is no annual contribution limit. However, annual contributions in excess of the annual gift tax exclusion ($14,000 in 2013, 2014 and 2015) may consume part of the contributor’s lifetime gift tax exclusion, unless the contributor elects to use five-year gift tax averaging. Five-year gift-tax averaging treats the contribution as through it is spread uniformly across the next five years for gift-tax exclusion purposes.

Cumulative contribution limits vary by state and are typically based on the projected future cost of 5-7 years of college at the highest-cost public or private college in the state, typically around $350,000.

Contributions are not subject to any age limits.

Families may set up a 529 plan directly with the state (direct-sold) or through an investment adviser (adviser-sold). Direct-sold 529 plans usually have lower fees.

Investments

Each 529 plan offers a small number of mutual funds as investment options, such as an S&P 500 index fund and a bond fund. Account owners may change the investments once a year, but may not otherwise direct or control the investments or the investment strategy.

Most 529 plans offer an age-based asset allocation. This is like a target date fund for retirement plans. It starts off with an aggressive mix of investments when the child is young and gradually shifts it to a more conservative mix of investments as college approaches. About two-thirds of families use an age-based asset allocation.

Distributions

Distributions from a 529 plan are tax-free if they are used to pay for qualified higher education expenses, which include tuition and fees, books, supplies, equipment, and expenses for special-needs services required for enrollment or attendance. If the student is enrolled on at least a half-time basis, room and board (up to the allowances set by the school or actual charges for institutionally owned or operated housing) is also considered to be a qualified higher education expense.

Distributions to pay down the balance on a student loan are not currently a qualified higher education expense. Such distributions are considered a non-qualified distribution.

There is no age limit on distributions from a 529 college savings plan. The account owner may also change the beneficiary to a relative of the beneficiary.

Impact on Eligibility for Need-Based Financial Aid

529 college savings plans also provide favorable financial aid treatment.

If a 529 plan is owned by a dependent student or the dependent student’s parent, it is reported on the Free Application for Federal Student Aid (FAFSA) as though it were a parent asset. Parent assets are not assessed as heavily as student assets. Distributions from such a 529 plan are not reported as income on the FAFSA.

If a 529 plan is owned by an independent student, it is reported as a student asset on the student’s FAFSA. This includes any 529 plans that are owned by the student which list the student’s children as beneficiaries. Distributions are not reported as income on the FAFSA.

If the 529 plan is owned by anybody else, including grandparents, aunts, uncles, the non-custodial parent (if the student’s parents are divorced) and unrelated individuals, it is not reported as an asset on the FAFSA. Distributions from such a 529 plan, however, are reported as untaxed income to the student on the FAFSA. Untaxed income has the same impact as adjusted gross income (AGI) on the student’s eligibility for need-based financial aid. As much as half of the untaxed income will reduce the student’s aid eligibility on the subsequent year’s FAFSA. Account owners can avoid the negative impact of such 529 plans by changing the account owner to be the parent or by waiting until after the student files the FAFSA for the student’s senior year in college to take a distribution, assuming the student is not planning to attend graduate or professional school immediately following completion of the undergraduate degree.