Used with permission from The United States Securities and Exchange Commission.
The birth of a child is an exciting time for the entire family. Soon, that excitement turns to thoughts of serious financial planning. It may be the first time you've considered the importance of life insurance and estate planning. You may also wonder how to budget for the long-term costs of child rearing, and how to protect and provide for your child's financial future.
In this section, we’ve highlighted two ways to invest for a child’s education. Savings bonds provide a safe investment and are one of the few investment options that can be held in the child’s name. We’ve also included information on 529 Plans that can help you to start saving now, so that when your baby is headed to college, you’ll be prepared.
Saving for Education - 529 Plans
What is a 529 plan?
A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. These 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: pre-paid tuition plans and college savings plans. All 50 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 pre-paid tuition plan.
What are the differences between pre-paid tuition plans and college savings plans?
Pre-paid tuition plans generally allow college savers to purchase units or credits at participating colleges and universities for future tuition and, in some cases, room and board. Most prepaid tuition plans are sponsored by state governments and have residency requirements. Many state governments guarantee investments in pre-paid tuition plans that they sponsor.
College savings plans generally permit a college saver, also called the “account holder,” to establish an account for a student (the “beneficiary”) for the purpose of paying for the beneficiary’s eligible college expenses.
An account holder may typically choose among several investment options which often include stock mutual funds, bond mutual funds, and money market funds, as well as age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age.
Withdrawals from college savings plans generally can be used at any college or university. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured.
Here are some of the major differences between pre-paid tuition plans and college savings plans.
|Prepaid Tuition Plan||College Savings Plan|
|Locks in tuition prices at eligible public and private colleges and universities.||No lock on college costs.|
|All plans cover tuition and mandatory fees only. Some plans allow you to purchase a room & board option or use excess tuition credits for other qualified expenses.||Covers all "qualified higher education expenses," including: tuition, room & board, mandatory fees, books, and computers (if required).|
|Most plans set lump sum and installment payments prior to purchase based on age of beneficiary and number of years of college tuition purchased.||No state guarantee. Most investment options are subject to market risk. Your investment may make no profit or even decline in value.|
|Most plans have age/grade limit for beneficiary.||No age limits. Open to adults and children.|
|Most state plans require either owner or beneficiary of plan to be a state resident.||No residency requirement. However, nonresidents may only be able to purchase some plans through financial advisers or brokers.|
|Most plans have limited enrollment period.||Enrollment open all year.|
Source: Smart Saving for College, FINRA®
How does investing in a 529 plan affect federal and state income taxes?
Investing in a 529 plan may offer college savers special tax benefits. Earnings in 529 plans are not subject to federal tax, and in most cases, state tax, provided you use withdrawals for eligible college expenses, such as tuition and room and board.
However, if you withdraw money from a 529 plan and do not use it for an eligible college expense, you generally will be subject to income tax and a 10% federal tax penalty on earnings. Many states offer state income tax or other benefits, such as matching grants, for investing in a 529 plan. But you may only be eligible for these benefits if you participate in a 529 plan sponsored by your state of residence. Just a few states allow residents to deduct contributions to any 529 plan from state income tax returns.
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 plan. Prepaid tuition plans typically charge enrollment and administrative fees. In addition to “loads” for broker-sold plans, college savings plans may charge enrollment fees, annual maintenance fees, and asset management fees.
Some of these fees are collected by the state sponsor of the plan, and some are collected by the financial services firms hired by the state sponsor to manage the 529 program. Some college savings plans will waive or reduce some of these 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.
Is there any way to purchase a 529 plan but avoid some of the extra fees?
Direct-Sold College Savings Plans. States offer college savings plans that residents and, in many cases, non-residents can invest in without paying a "load," or sales fee. This type of plan, which you can buy directly from the plan's sponsor or program manager without the assistance of a broker, is generally less expensive because it waives or does not charge sales fees that may apply to broker-sold plans. For information, contact the plan’s sponsor or program manager or visit the plan’s website. Websites such as the one maintained by the College Savings Plan Network, as well as a number of commercial websites, provide links to most 529 plan websites.
Does investing in a 529 plan impact financial aid eligibility?
Investing in a 529 plan generally will reduce a student’s eligibility to participate in need-based financial aid. Assets held in pre-paid tuition plans and college savings plans have been treated similarly for federal financial aid purposes since mid-2006. Both are treated as parental assets when calculating the expected family contribution toward college costs.
What questions should I ask before I invest in a 529 plan?
Is the plan available directly from the state or plan sponsor?
What fees are charged by the plan? How much of my investment goes to compensating a broker? Under what circumstances does the plan waive or reduce certain fees?
What are the plan’s withdrawal restrictions? What types of college expenses are covered by the plan? Which colleges and universities participate in the plan?
What types of investment options are offered by the plan? How long are contributions held before being invested?
Does the plan offer special benefits for state residents? Would I be better off investing in my state’s plan or another plan? Does my state’s plan offer tax advantages or other benefits for investment in the plan it sponsors? If my state’s plan charges higher fees than another state’s plan, do the tax advantages or other benefits offered by my state outweigh the benefit of investing in another state’s less expensive plan?
What limitations apply to the plan? When can an account holder change investment options, switch beneficiaries, or transfer ownership of the account to another account holder?
Who is the program manager? When does the program manager’s current management contract expire? How has the plan performed in the past?
Where can I find more information?
Often called a “disclosure statement,” “disclosure document,” or “program description,” the offering circular for a 529 plan will have detailed information about the plan, including investment options, tax benefits and consequences, fees and expenses, financial aid, limitations, and risks. Most 529 plans post their offering circulars online. The National Association of State Treasurers created the College Savings Plan Network, which provides links to most 529 plan websites.
Savings bonds are a popular gift upon the birth of a child. One reason is that unlike other securities, minors may hold U.S. savings bonds in their own name.
Savings bonds are debt securities issued by the U.S. Department of the Treasury to help pay for the U.S. government’s borrowing needs. U.S. savings bonds are considered one of the safest investments because they are backed by the full faith and credit of the U.S. government.
There are several types of U.S. savings bonds.
- Series EE Bonds. These bonds are available in paper and electronic versions. In both cases, you cannot buy more than $5,000 (face value) during any calendar year. If you redeem the bonds in the first five years of buying them, you’ll forfeit interest payments for the three most recent months. After five years, you won’t be penalized for redemptions.
- Paper EE Bonds are purchased at a discount of half their face value, so you’ll pay $25 for a $50 bond. Paper EE Bonds increase in value as the interest is added to the principal. When paper EE Bonds mature in 30 years, you’ll receive all of the money you paid for the bonds originally plus all of the interest.
- Electronic EE Bonds are sold at face value, so you’ll pay $50 for a $50 bond. The bond is worth its full value upon redemption. The interest is issued electronically to your designated account.
- Series I Bonds. Like EE Bonds, I Bonds are available in paper and electronic versions. These bonds are sold at face value and you can buy up to $5,000 (face value) in any calendar year. Series I Bonds offer a fixed rate of interest, adjusted for inflation. As with Series EE Bonds, if you redeem Series I Bonds in the first five years, you’ll forfeit the three most recent months’ interest. After five years, you won’t be penalized for redemptions.
U.S. savings bonds provide tax advantages. You pay no state or local taxes on the interest on the bonds and you can defer paying federal taxes on the interest until you cash in the bond or until it matures. In addition, a savings bond education tax exclusion permits qualified taxpayers to exclude from their gross income all or part of the interest paid upon the redemption of eligible Series EE and I Bonds issued after 1989, when the bond owner pays for certain expenses, such as tuition and fees, at eligible colleges, universities, and vocational schools.
U.S. savings bonds are registered with the U.S. Department of the Treasury’s Bureau of the Public Debt, so you can get your bonds replaced if they are lost, stolen, or destroyed.