Becoming a parent for the first time has caused me to give much
consideration to paying for college. There are many programs that
facilitate this process, but I believe 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 federal government, they are run by all 50 of the
individual states (at the time of this post, anyway…rumor has it that
Wyoming is mulling the consolidation of its plan with Colorado). 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. Today
I am going to focus on the general savings plan, and will address the
prepaid approach in a future post.
The general savings approach within a 529 allows for substantial
funds to be set aside to grow on a tax-free basis, as long as the funds
are ultimately used toward educational purposes. I say “substantial”
rather than a specific dollar limit because 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income tax will be assessed on the earnings when they are withdrawn,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
Unlike prepaid programs, these general savings plans
allow for the funds to be used at any legitimate educational
institution. By way of example, Nevada allows for a maximum of $250,000
to be saved, and Arizona allows for $289,000.
The owner of the account, who is also typically the
primary contributor, controls the account. This generally means that
the beneficiary does not have much control. A key control feature is
the ability for the owner to change beneficiaries 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 the deduction, that is the first place to look, in
my opinion. The deduction may not overcome a poorly managed plan,
The tax free withdrawal benefits conveyed by these plans are currently
covered under the tax law through 2010. It is generally assumed that
these benefits will be extended, but it’s definitely not guaranteed.
Nonetheless, the average 18 year old beneficiary, who will be
responsible for the taxes, will typically be in a lower tax bracket
than the contributor. Thus, the benefit remain would remain, although
it would be dramatically reduced.
What to look for in a 529 plan
In choosing a 529 plan for my children, I evaluated options based
on several criteria. Some that I think are particularly important
Ability to take advantage of state tax deductions for
residents. I live in Arizona, which does not offer this perk, but it
would definitely be a key consideration if I lived in a state like New
Mexico, which offers full deductibility.
Low fees and expenses. This is key, as these expenses
reduce the investment return. I’m not a financial advisor and suffer
from no conflicts of interest, so I can freely state that I like
Vanguard mutual funds because they tend to have low expenses. Many 529s
either use Vanguard to run the program, or leverage their funds within
Several investment options. Many plans offer
age-based portfolios, 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, i.e. 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
Minimum contribution levels that are appropriate to a
given situation. 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.
Research is required to decide which plan to adopt for a given
situation, but a few caught my eye. The College Savings Plan of
Nebraska is considered by some to be the best in the country. For the
most part, its expenses are very low, and the breadth of investment
options is impressive. It offers a stingy tax deduction for residents,
but something is better than nothing. The Utah Educational Savings Plan
(UESP) Trust has low expenses and a contribution limit of $315,000.
Nevada offers several well regarded 529 options, including The Upromise
College Fund, which is managed by Upromise Investments, and leverages
Vanguard funds. This is the plan that I selected, because it works
seamlessly with the Upromise program, which I also recommend. For those
who have not consumed the Upromise Kool-Aid, as I have, Nevada also
offers The Vanguard 529 Savings Plan, which is also managed by Upromise
and has similarly low expenses, with an even wider choice of investment
options. I also think Illinois’ Bright Start College Savings Program,
which is managed by Citigroup Asset Management, is solid, particularly
for Illinois residents.