Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Forget Student Loans -- Try This Tax-Friendly Account You've Probably Forgotten

The Federal Reserve says inflation remains well in check. But tell that to the millions of students pursuing higher education and you’ll likely get a glaring look.

The cost of tuition has skyrocketed in the last 30 years. According to Bloomberg, college tuition fees have increased 1,100% since Bloomberg started keeping records in 1978. That handily outpaces the 601% increase in medical expenses and 244% increase in food prices.

And that trend shows little sign of slowing. According to The College Board, tuition costs are up another 4.2% in 2013 at private colleges and 4.8% at public universities, with both figures outpacing increases in the inflation rate and growth in personal income.

Four years at a private college beginning in 2012 is estimated at $127,000, The College Board reports, while in-state tuition at a public university for that period is $37,800. Extrapolating those growth rates 18 years into the future -- when today's newborns will begin attending college -- The College Board estimates that in 2030 tuition at a private college will total $362,000 and $108,000 for an in-state public university. And that’s just the cost of tuition, excluding housing, books and food.

As you can see, out-of-control tuition expenses are creating big financial challenges for families and individuals pursuing education. That has been fueling the growing popularity of a little-used investment account that makes tuition more affordable.

A 529 plan is a tax-advantaged investment account offered in the United States that encourages savings for education expenses by providing big tax benefits.

On the federal level, although contributions are not deductible from taxable income, both gains and distributions are tax exempt. Many plans also offer tax benefits on the state level, offering income-tax deductions on contributions, creating a powerful financial incentive for families and individuals investing in education.

There are two kinds of plans:

Savings Plans

The savings plan works like a 401(k) or IRA; account holders are eligible to invest in a list of securities such as mutual funds and ETFs. The value of the account will then fluctuate based upon the performance of the investments.

Many 529 plans also offer target-date funds, where the underlying investment mix becomes more conservative as the beneficiary moves closer to college. Although states administer savings plans, record-keeping and administrative services for savings plans are usually managed by a mutual fund or financial services company.

Prepaid Plans

The prepaid plan enables participants to lock in current tuition rates for future use. That means the performance and value of the account is based on tuition inflation rates as opposed to invested securities. Prepaid plans may be administered by states or higher education institutions. There are currently 11 states offering prepaid plans.

The prepaid plan enables account holders to prepay all or a portion of the costs of an in-state public institution. Prepaid plans are also eligible to be converted for use at private and out-of-state schools.

But whether the savings or prepaid plan is the best fit, distributions from a 529 plan can be used for tuition, fees, books, supplies and equipment necessary to pursue a degree at any accredited college, university or vocational school in the United States and at some foreign universities.

Funds can also be used for room and board if the fund beneficiary is at least a half-time student. Off-campus housing costs are covered under a schedule for room and board that the college includes in its cost of attending for federal financial-aid purposes.

What Can You Do With Unused Funds?

Another benefit of the 529 plan is the account holder’s eligibility to transfer unused funds to other qualified members of the beneficiary's family without incurring any tax penalty. The IRS describes this transfer as a rollover and does not require reporting anywhere on Form 1040 or 1040NR.

529 plans also offer plenty of flexibility if funds go unused. Not only does the donor maintain control of the account, the beneficiary has no rights to the funds. Many plans even allow participants to reclaim funds for themselves at any time with no taxes or penalties. Non-qualified distributions, however, carry a 10% penalty and gains are taxed as regular income.

Fees And Eligibility

529 plans are also big on value, with startup and minimum contribution requirements low relative to other investment accounts such as the 401(K) and annuities. The 529 plan is also extremely inclusive, carrying no age or income restrictions. Many states also have robust account value limits, with some reaching up to $300,000.

The Investing Answer: Enrolling in a 529 plan is easy. Plans are offered through many financial services companies and require a simple enrollment application. The management of the account is handled by the state treasury office or by a third-party investment management company based on the account-holder’s risk profile. Account holders do not receive a 1099 to report taxable income until withdrawals are made. Account holders have the option to adjust their investment mix or roll into another state’s plan every 12 months.

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