The SEC’s Office of Investor Education and Advocacy is issuing this Investor Bulletin to provide investors with background information on 529 plans. Please also see our companion Bulletin for a few questions to consider before opening a 529 plan account.
What is a 529 plan?
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. 529 plans, legally known as “qualified tuition plans,” are sponsored by states, state agencies, or educational institutions and are authorized by Section 529 of the Internal Revenue Code.
There are two types of 529 plans: prepaid tuition plans and education savings plans. All fifty states and the District of Columbia sponsor at least one type of 529 plan. In addition, a group of private colleges and universities sponsor a prepaid tuition plan.
What are the differences between prepaid tuition plans and education savings plans?
Prepaid Tuition Plans. Prepaid tuition plans let a saver or account holder purchase units or credits at participating colleges and universities (usually public and in-state) for future tuition and mandatory fees at current prices for the beneficiary. Prepaid tuition plans usually cannot be used to pay for future room and board at colleges and universities and do not allow you to prepay for tuition for elementary and secondary schools.
Most prepaid tuition plans are sponsored by state governments and have residency requirements for the saver and/or beneficiary. Prepaid plans are not guaranteed by the federal government. Some state governments guarantee the money paid into the prepaid tuition plans that they sponsor, but some do not. If your prepaid tuition payments aren’t guaranteed, you may lose some or all of your money in the plan if the plan’s sponsor has a financial shortfall. In addition, if a beneficiary doesn’t attend a participating college or university, the prepaid tuition plan may pay less than if the beneficiary attended a participating college or university. It may only pay a small return on the original investment.
Education Savings Plans. Education savings plans let a saver open an investment account to save for the beneficiary’s future qualified higher education expenses – tuition, mandatory fees and room and board. Withdrawals from education savings plan accounts can generally be used at any college or university, including sometimes at non-U.S. colleges and universities. Education savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at any public, private or religious elementary or secondary school.
A saver may typically choose among a range of investment portfolio options, which often include various mutual fund and exchange-traded fund (ETF) portfolios and a principal-protected bank product. These portfolios also may include static fund portfolios and age-based portfolios (sometimes called target-date portfolios). Typically age-based portfolios automatically shift toward more conservative investments as the beneficiary gets closer to college age. If you are using a 529 account to pay for elementary or secondary school tuition, you may have a shorter time horizon for your money to grow. You also may not feel comfortable taking on riskier or more volatile investments if you plan on withdrawing the money soon. Because of these things, you may consider different investment options depending on when you plan to use the money that is invested.
All education savings plans are sponsored by state governments, but only a few have residency requirements for the saver and/or beneficiary. State governments do not guarantee investments in education savings plans. Education savings plan investments in mutual funds and ETFs are not federally guaranteed, but investments in some principal-protected bank products may be insured by the FDIC. As with most investments, investments in education savings plans may not make any money and could lose some or all of the money invested.
What fees and expenses will I pay if I invest in a 529 plan?
It is important to understand the fees and expenses associated with 529 plans because they lower your returns. Fees and expenses will vary based on the type of 529 plan (education savings plan or prepaid tuition plan), whether it is a broker- or direct-sold plan, the plan itself and the underlying investments. You should carefully review the plan’s offering circular to understand what fees are charged for the plan and each investment option.
Prepaid Tuition Plans. Prepaid tuition plans may charge an enrollment/application fee and ongoing administrative fees.
Education Savings Plans. Education savings plans may charge an enrollment/application fee, annual account maintenance fees, ongoing program management fees, and ongoing asset management fees. Some of these fees are collected by the state sponsor of the plan and some are collected by the plan manager. The asset management fees will depend on the investment option you select. Investors that purchase an education savings plan from a broker are typically subject to additional fees, such as sales loads or charges at the time of investment or redemption and ongoing distribution fees.
Fee Saving Tips. Many states offer direct-sold education savings plans in which savers can invest without paying additional broker-charged fees. In addition, some education savings plans will waive or reduce the administrative or maintenance fees if you maintain a large account balance, participate in an automatic contribution plan, or are a resident of the state sponsoring the 529 plan. Some 529 plans also offer fee waivers if the saver accepts electronic-only delivery of documents or enrolls online.
How does investing in a 529 plan affect federal and state income taxes?
Investing in a 529 plan may offer savers special tax benefits. These benefits vary depending on the state and the 529 plan. In addition, state and federal laws that affect 529 plans could change. You should make sure you understand the tax implications of investing in a 529 plan and consider whether to consult a tax adviser.
Contributions. Many states offer tax benefits for contributions to a 529 plan. These benefits may include deducting contributions from state income tax or matching grants but may have various restrictions or requirements. In addition, savers may only be eligible for these benefits if you invest in a 529 plan sponsored by your state of residence.
Withdrawals. If you use 529 account withdrawals for qualified higher education expenses or tuition for elementary or secondary schools, earnings in the 529 account are not subject to federal income tax and, in many cases, state income tax. However, if 529 account withdrawals are not used for qualified higher education expenses or tuition for elementary or secondary schools, they will be subject to state and federal income taxes and an additional 10% federal tax penalty on earnings.
One of the benefits of 529 plans is the tax-free earnings that grow over a period of time. The longer your money is invested, the more time it has to grow and the greater your tax benefits. You will lose some of these potential benefits if you withdraw money from a 529 plan account within a short period of time after it is contributed.
What restrictions apply to an investment in a 529 plan?
There will likely be restrictions on any 529 plan you may be considering. Before you invest in a 529 plan, you should read the plan’s offering circular to make sure that…