The Basics of 529 Plans

The Section 529 College Savings Plan is a tax favored investment plan offered by states as a way to help families save for college expenses. Named "529 Plans" for the Internal Revenue Code Section which created them (that is Internal Revenue Code section 529), these state managed college savings plans allow for the saving of money for secondary education (generally, college and graduate school) on an income tax deferred basis, with eventual withdrawals for payment of education expenses being federally (and sometimes state) income tax free. 529 Plans are often managed by mutual fund or financial services companies on behalf of the States.

Code Section 529 allows each state to offer the 529 College Savings Plan that the state creates and manages (or as managed by a financial services company) to its residents and in many cases to non-residents of the state. While assets are growing in the 529-plan portfolio, all income tax is deferred so that the investments can grow without the shrinking caused by taxing the income as it is earned.

For the earnings on the 529 Plan account to be federally income tax free when withdrawn, the account assets must be withdrawn for payment of "qualified higher education expenses", and used at an "eligible educational institution".

The owner of the 529 Account can be the person who creates the account, or the beneficiary of the account, or some other person, trust, or other entity. The owner of the account is the only one who can decide when a withdrawal is being made, and for what purpose. The owner is also the only one who can change the beneficiary. If the beneficiary rules are followed, the owner can change beneficiaries from time to time without causing the investments in the account to be taxed.

To promote gift giving into a 529 College Savings Plan account, special gift rules exist. Gifts can be made of the allowable $11,000 per year, per person, into a 529 Plan account. The special rules allow for someone to make 5 years worth of these gifts all at once and "stretch" the gift over 5 years. This allows a larger pool of assets to grow tax-deferred, sooner. It is to be expected that changes will be made on a frequent basis, both to the governing Internal Revenue Code Section, but also to the Regulations that will soon be issued.

An item to keep track of is the possibility that the Section 529 College Savings Plan and its governing law may "sunset" on December 31, 2010. The "sunset" provision requires additional legislation to keep the Section 529 College Savings Plan law on the books. If the law "sunsets" without any changes being made then the 529 College Savings Plan would no longer exist. As a result, many of the following would expire on that date: tax free distributions of earnings for "qualified higher education expenses", the ability to rollover plan assets without a change of beneficiary, the ability to contribute to a Coverdell Savings Account in the same year as a contribution is made to a College Savings Account, rules about applicability of the 529 College Savings Plan to "special needs" individuals, and the coordination with HOPE Scholarships and Lifetime Learning Credits. Many commentators have indicated that it is unlikely that Congress will allow this to occur. Other industry commentators have indicated that if the law sunsets they expect that all existing accounts will be allowed to retain the existing special tax benefits of 529 College Savings Plan (that is "grandfathering" the existing accounts).

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