Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

Section 529 college savings plans are state-sponsored arrangements named after the section of Tax Code that authorizes wonderfully favorable treatment under the federal income and gift tax rules. (Section 529 plans are also sometimes called qualified tuition programs even though they generally cover room and board as well as tuition.) 

The parent (or grandparent) of the college-bound child starts the ball rolling by making contributions into a trust fund set up by the state plan that is selected. The money goes into an account designated for the beneficiary specified by the contributor (the client). In most cases, the account beneficiary is the client’s child, but it can also be a grandchild or any other young person the client wishes to help. Contributions can be in the form of a one-time, lump-sum pay-in or in the form of installment pay-ins stretching over several years. The plan then invests the money. Once the account beneficiary reaches college age, withdrawals are taken to pay eligible college expenses (including room and board under most plans). Plans generally cover expenses at any accredited college or university in the country (not just schools within the state sponsoring the plan). Community colleges qualify as well. In essence, a Section 529 college savings plan account is nothing more than a tax-advantaged way to build up a college fund. The account beneficiary is not guaranteed admittance to any particular college.

The cost to attend whichever school that is ultimately chosen is not locked in by the arrangement. Finally, most plans do not guarantee any minimum rate of return. (See the later discussion of the important distinction between Section 529 college savings plans and Section 529 prepaid tuition plans.) Most college savings plans now permit lump-sum contributions of well over $300,000. So clients can really jump-start the child’s (or grandchild’s) college fund if they have the money to do so. If not, clients can make installment pay-ins. Of course, the sooner substantial dollars are put into the college savings plan account, the sooner the tax benefits start accruing. 

Almost all Section 529 college savings plans now offer several investment alternatives, including equity mutual funds and more conservative options like bond and money market funds. More than a few plans welcome out-of-state investors. There is also a growing trend towards hiring pros to manage the money. For example, the New Hampshire, Delaware, and Massachusetts programs are managed by Fidelity Investments. 

Just a few years ago, critics were complaining that many Section 529 college saving plans did not offer enough really aggressive investment programs, such as strategies emphasizing an unwavering commitment to so-called growth stocks. After several stock market meltdowns in recent years, that complaint is not heard much anymore. Relatively conservative investment strategies now seem rather smart, and most Section 529 college savings plans offer at least one of those. That said, many plans now offer relatively aggressive equity-oriented strategies too. Clients can take their choice.

Tax-wise, the very best thing about Section 529 college savings plan accounts is they allow earnings to build up federal-income-tax-free. The earnings can be withdrawn federal-income-tax-free to pay college costs. As for state income taxes, most states provide that there is no liability when both the contributor and the account beneficiary reside in the state sponsoring the plan. However, there are exceptions. For example, California taxes the account beneficiary when he or she withdraws earnings. Until then, earnings are tax deferred for California state income tax purposes.

When the client invests in an out-of-state plan, the state income tax consequences may be unclear. In fact, this question mark is one of the few potential negatives about Section 529 plans. Presumably, most or all states will eventually offer tax-free treatment just like the federal government, and the state tax questions will die. In any case, the federal tax benefits far outweigh any state tax concerns. 

On a brighter note, several states go beyond just allowing state-income-tax-free payouts by offering additional tax incentives to encourage residents to contribute to the in-state plan. Illinois, for example, allows deductions for contributions to its plan up to $20,000.