529 College Savings Plans Pros and Cons

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529 College Savings Plans

If you are wondering what is 529 college savings plan, then, you are not alone. You’ve probably heard about qualified 529 plans or state-sponsored 529 college savings plans. Congress created Section 529 plans in 1996 and by now 529 plans have emerged as one of the popular ways to save money for college. Section 529 plans are officially known as “qualified tuition programs” under federal law.

What, exactly, is a 529 plan?

A 529 college savings plan or program is a college funding vehicle that has federal tax advantages. There are two types of 529 plans: (1) college funding (or savings) plans and (2) prepaid tuition plans. Although college funding plans and prepaid tuition plans share the same federal tax advantages, there are important differences between them.

(1) Section 529 College Savings Plans:

529 college savings plans let you save money for college in an individual investment account. These plans are run by the states, which typically designate an experienced financial institution to manage their plan. To open an account, you fill out an application, choose a beneficiary, and start contributing money. After this, you simply decide when, and how much, to contribute.

The plan investment managers commonly invest your money based only on the age of your beneficiary (this is known as an age-based portfolio). Under this model, when a child is young, most of the portfolio’s assets are allocated to aggressive investments. Then, as a child grows, the portfolio’s assets are gradually and automatically shifted to less volatile investments to preserve principal. The idea is to take advantage of the stock market’s potential for high returns when a child is still many years away from college, then to lessen the risk of these investments in later years. When it’s time for college, the beneficiary can use the funds at any college in this country and abroad, as long as it is accredited by the U.S. Department of Education.

(2) Section 529 Prepaid Tuition Plans:

Prepaid tuition plans let you save money for college, too, but in a different way. Prepaid tuition plans may be sponsored by states (on behalf of public universities) or by private colleges. A prepaid tuition plan lets you prepay tuition expenses now for use in the future. The plan’s money manager pools your contributions with those from other investors into one general fund. The fund assets are then invested to meet the plan’s future obligations. Many plans even guarantee a minimum rate of return. The most common type of prepaid tuition plan is a contract plan. With a contract plan, in exchange for your up-front cash payment (or series of payments), the plan promises to cover a predetermined amount of future tuition expenses at a particular college in the plan. These plans have different criteria for determining how much they’ll pay out in the future. And if your beneficiary ends up choosing to attend a school that isn’t in the prepaid plan, you’ll typically receive a lesser amount according to a predetermined formula.

The other type of prepaid tuition plan is a unit plan. You purchase units or credits that represent a percentage (typically 1 percent) of the average tuition costs at the plan’s participating colleges. Instead of having a predetermined value, these units or credits fluctuate in value each year according to the average tuition increases for that year. You then redeem your units or credits in the future to pay tuition costs, and many plans also let you use them for room and board, books, and other supplies. A final note to keep in mind: Make sure you understand what will happen if a plan’s investment returns can’t keep pace with tuition increases at the colleges participating in the plan. Will your tuition guarantee be in jeopardy? Will your future purchases be limited or more expensive?

The Pros of 529 College Savings Plans

  • Federal and state tax-deferred growth: The money you contribute to a state-sponsored qualified 529 plan is after taxed dollars but grows tax-deferred each year. Your earnings will be free of federal tax, as long as the money is used for college (known under federal law as a “qualified withdrawal”).
  • Favorable federal gift tax treatment: Contributions to a 529 plan are considered completed, present-interest gifts for gift-tax purposes.
  • Favorable federal estate tax treatment: Your plan contributions aren’t considered part of your estate for federal tax purposes.
  • State tax advantages: States can also add their own tax advantages to 529 plans. For example, some states exempt qualified withdrawals from income tax or offer an annual tax deduction for your contributions.
  • Availability: Section 529 plans are open to anyone, regardless of income level. And you don’t need to be a parent to set up an account.
  • High contribution limits: The total amount you can contribute to a 529 plan is generally high. Most plans have limits of $250,000 and up.

The Cons of 529 College Savings Plans

  • Investment risk: 529 college savings plans don’t guarantee your investment return. You can lose some or all of the money you have contributed. Even though prepaid tuition plans typically guarantee your investment return, some plans change the benefits they’ll pay out due to projected actuarial deficits.
  • Inflexible investment: If you’re unhappy with your portfolio’s investment performance in your college savings plan, you typically can direct future contributions to a new portfolio (assuming your plan allows it), but it may be more difficult to redirect your existing contributions.
  • Penalty on nonqualified withdrawals: If you want to use the money in your 529 plan for something other than college, it’ll cost you. With a 529 college savings plan, you’ll pay a 10 percent federal penalty on the earnings part of any withdrawal that is not used for college expenses (a state penalty may also apply). You’ll pay income tax on the earnings, too. With a prepaid tuition plan, you must either cancel your contract to get a refund or take whatever predetermined amount the plan will give you for a nonqualified withdrawal (some plans may make you forfeit your earnings entirely; others may give you a nominal amount of interest).
  • Fees and expenses: There are typically fees and expenses associated with 529 plans. 529 plans may charge an annual maintenance fee, administrative fees, and an investment fee based on a percentage of your account’s total value. Prepaid tuition plans may charge an enrollment fee and various administrative fees.
  • No death or disability coverage: 529 plans are based on investment products and do not cover the risk of death and disability of the breadwinner. What will happen to your 529 plan if you die prematurely or become totally disabled? Who will continue fund 529 college savings plan?

Cash Value Life Insurance–based College Savings Plan

Cash Value Life Insurance based plan provides almost all the advantages of 529 college savings plans while eliminating the disadvantages.

  • Whole Life Insurance cash values receive pretty much the same favorable tax treatment as 529 plans (after federal income tax contribution, tax-deferred growth, and tax-free withdrawal via policy loan). Policy cash values can be borrowed against or withdrawn as a policy loan without any tax consequences for any purpose and at any time. If you do not use the money for qualified college expenses, there is no 10% IRS penalty, as there is with 529 plans.
  • Your family gets life insurance protection while also meeting the important financial goal of college financial planning. If you die prematurely, the death benefit is there to provide sufficient funds for your child’s education at his/her college of choice.
  • If you add the waiver of premium rider, if you become totally disabled because of a sickness or injury, the insurance company will pay your life insurance premiums. Therefore, your college savings plan will be self-completing.
  • In Cash Value Life Insurance policies, such as whole life insurance plans, you have the safety of a guaranteed cash value. You don’t have to risk losing it in the stock market!
  • Life insurance values are not included in the federal methodology for calculating financial aid, so you will not be penalized for saving money for college.

As you can see, Cash Value Life Insurance is a great college savings option for most scenarios. It gives you all the advantages of 529 college savings plans with the added advantage of paying a death benefit should you die prematurely or become totally disabled.

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