Pros and Cons of Section 529 Plans: A Look at the Benefits

Higher Returns Than Traditional Savings And Investment accounts

Saving money is the name of the game, but saving efficiently (and accepting help when offered) is the best way to go about it. Although the federal and state governments won't actually start a savings account for you or put money into one that you've opened, they do provide tools to help your savings grow.

Section 529 plans offer three ways by which your savings can grow faster than they would if you invested them in an ordinary investment account or in your local savings bank:

• Tax deferrals (postponing when you pay tax)
• Tax exemptions (not paying any income tax at all on earnings)
• State income tax deductions (sometimes being able to exclude your contributions from your income in the year that you make the contributions)

Here's how it works. George and Hannah, who are Maryland residents, have a baby in 2003. They don't have any savings in the bank, only the money that they currently earn, so they know that paying college costs 18 years down the road may be tough. George and Hannah think it's wise to start planning now.

They do their research and begin implementing their decisions as soon as the baby arrives. Their first decision is to open a Section 529 plan, and their second is to opt for four years of paid tuition in Maryland's prepaid tuition plan, which offers not only tax-free qualified distributions but also tax-free contributions. They both attended the University of Maryland, and they feel they received a fine education. It seems like a good choice for their baby.

George and Hannah know that the next 18 years are going to pass quickly and that their son will be heading off to the University of Maryland (or any other college or university, but they're loyal alumni, so Maryland seems the obvious choice) in 2020. By religiously making their payments into the plan, they know they'll have four years' worth of tuition credits when the time comes. They expect that their son, who they expect will be a motivated student, will complete his degree in four years, graduate, and start his working life with a reasonable job in a reasonable company.

Although the tuition will be the same, whether or not Hannah and George have a Section 529 plan, the amount of money they have to supply will not. Even if they fund a savings account with exactly the same amount of money as they fund an equivalent 529 plan, they'll have to pay federal and state income tax annually on income being earned. In addition, although no federal income tax deduction is allowed for contributions made into a 529 plan, Maryland provides one (as do many other states). In fact, if Hannah and George put their money into a traditional savings or investment account, they may pay more in tax in the years leading up to college than they would have if they'd funded a 529 prepaid tuition plan.

This example uses fairly generous rates of investment return and relatively moderate rates of tuition increase. Real life rarely follows planned examples exactly. If you're not using a Section 529 payment plan, you may need to adjust your budget and your savings accordingly.

Figure 7-2 illustrates how your money may grow in a 529 plan and how the same amount of periodic savings (whether you use weekly, monthly, or quarterly deposits) will cost you more if you put it into conventional investments outside of a 529 plan. As in Figure 7-1, which shows how the numbers work if you save the same amount each month, all numbers assume a 5 percent annual rate of return, and federal income taxes are calculated at 25 percent. No adjustment is made for state income tax (each state is individual in this regard), and most savings plans don't carry residency restrictions.

Figure 7-2 clearly shows that, over time, you'll save much more money if you don't pay tax currently on your earnings. If you live in a state that has a state income tax on investment income but that follows the Section 529 federal rules, the disparity between the Section 529 funds and the ordinary investment funds becomes even greater. Regardless of what your total rate of return is (and no one has any accurate idea what it will be until it's actually earned, although it could be much higher or lower, depending on market conditions and how aggressively you invest), saving money costs you less when you can save in a tax-deferred or tax-exempt account.

Flexibility Of Funding

Suppose that you're like George and Hannah — settled in one place with no plans to move — and you'd like nothing better than to see your children graduate from one of your state's colleges or universities. In that situation, investing in your state's prepaid tuition plan (if it has one) makes wonderful sense. But you don't have to be like George and Hannah in order to take advantage of a 529 plan, because there are not only state-run prepaid tuition plans but also savings plans and college-run prepaid tuition plans. So, if you're saving for the day your child goes to almost any sort of postsecondary school, some 529 plan out there should fit your needs, whatever they are.

Take, for example, Lisa and Sean, who have a newborn and a 15-year-old for whom they haven't begun saving. Because they're always on the move from one state to another, they don't think that investing in a prepaid tuition plan will work for them because of residency requirements built into so many of them. They also like having very few restrictions on where their children can attend postsecondary school. They decide to invest in a 529 savings plan.

With two children of very different ages to save for, Lisa and Sean can open Section 529 plans for each of them but fund the plans unequally, putting more into the older child's account to beef up savings there and then superfunding the younger child's account after the older child finishes his education. If any money is left in the older child's account after his education is complete, Lisa and Sean have the option of making a tax-free rollover of the remaining balance into the younger child's account.

No Taxes To Pay (At Least For Now)

Saving money is saving money, whether you put cash into a savings account or cut needless expenses. Section 529 plans help you to do both. While you're busy stashing as much away as you can, you're also, at the very least, postponing any income tax reckoning. You may be eliminating it altogether.

When your distribution program finally begins, any tax on accumulated earnings within the plan is paid by the person to whom, or for whose benefit, the distribution is made. So if you make the distributions for your benefit, you pay the tax; if your designated student is someone else (and it usually is), that person is responsible for any income taxes owed. Currently, the income portion of distributions that pay qualified educational expenses aren't being taxed at the federal level at all, and many states are following suit. Congress may choose to make that exemption permanent, but even if it doesn't and the provision sunsets in 2010, you and your student will still realize great tax savings by using a Section 529 plan.