529 plans for college expenses are very cool but extremely quirky. Cool federal-tax benefits, which were temporary and set to expire in just a few years, have been made permanent by The Pension Protection Act of 2006 (USA). The quirkiness and murkiness remains, however, but is made much clearer by the kind folks at Kiplinger.com, who have provided me (and anyone with an Internet connection) with some great resources, discussed here but awaiting your further perusal, beginning with these articles on saving for college and 529 college-savings plans.  

What are 529 plans? They are college savings programs created by individual states as authorized by Section 529 of the Internal Revenue Code. There are two kinds of 529s: prepaid tuition plans and college savings plans.

States sponsor programs and most outsource investment services to third-party firms such as Vanguard or T. Rowe Price. (The outsourcing of investment plans with pre-designed portfolios was a source of confusion and annoyance for me when I first started investigating these programs but the concept is similar to how employers offer 401(k) plans with multiple but finite investment plans that are designed and serviced by outside entities.)

The original intent for Section 529 rule, from what I can glean, was to provide a mechanism to prepay tomorrow’s tuition at today’s rates. Locking in tuition rates at a state-supported college or university (using a prepaid plan), though attractive, is not widely available. According to Kiplinger’s 529 plan locator, only 18 states have prepaid plans (prepaid contracts or prepaid units / guaranteed savings) and, of those, only 5 have "program benefits backed by the full faith and credit of the state” with an additional 5 having other types of guarantees (according to one of the "compare by questions" sections on Kiplinger's site, September 12, 2007).

If you are considering a private college or university, however, there is a prepaid program: Independent 529 Plan sponsored by Tuition Plan Consortium LLC and managed by TIAA-CREF Tuition Financing Inc. According to the plan’s website, contracts with private colleges and universities specify that units bought at a discount today must be honored tomorrow. You can visit its website to view participating institutions.

Though the prepaid programs may not be available for your state or desired institution of higher learning, there are tax benefits that should place investigating, selecting, and funding a 529 Plan on a parents’ to-do list. Before you decide on which program to select, here’s what’s cool and what’s quirky:

Cool

  • Earnings (e.g., capital gains, interest, and dividends) grow tax deferred.
  • 529s are treated as parental assets for financial aid purposes.
  • Grandparents (and others) can fund 529 plans with no impact on the student’s financial aid status.
  • If one child doesn’t need any or all of the money, funds can be moved to other 529 accounts; Kiplinger has supplied a list of approved transfers here.
  • Most 529 plans allow you to use funds for expenses at nearly any U.S. college or university.

Quirky

  • Individual states contract with third parties to manage programs. These firms offer investment options and pre-designed portfolios, some of which are age-based so that the stock/bond ratio converts from heavily weighted with stocks to heavily weighted with bonds as the beneficiary/student gets older and ready to use the money for college. 
  • Some options are offered only through brokers; others are available for direct purchase. You can find either type using Kiplinger's plan locator.
  • You can choose a plan sponsored by your state or you can invest in a plan sponsored by another state, though you will most likely forgo certain benefits (such as state income tax deductions) if you go with an out-of-state plan. 
  • State income tax benefits differ widely and contribution limits vary by state.
  • There may be account maintenance fees (flat fees) and service charges (usually % of assets).
  • You can change plans but usually just once a year.

The real value of the 529 Plan is that withdrawals for qualified educational expenses can be made free of federal income taxes. Remember to make sure that withdrawals don’t exceed qualified expenses as any excess amounts will result in unearned income to the beneficiary (student). And if the money is not used for college, then earnings are taxed at your regular income rate plus 10%, according to The New Math of Paying for College.

Now, that you've decided (most likely) to open a 529, which one should you choose? Kiplinger has state-by-state recommendations with rationale for its recommendations that I found useful.

Here are factors to consider in selecting a plan (each will impact your college cash flow in some way):

  • Availability of pre-paid plans in your home state or for your desired college/university;
  • State income tax benefits;
  • Account maintenance fees and service charges;
  • Potential investment returns.

Though the 529 plans may not offer significant immediate benefits to all U.S. parents, investing now could yield great advantages to your tax bill and cash flow later. As state offerings (investment plans) change, you'll be wise to evaluate plans now and review your choices every year but the time (and money) invested should be worth it.