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: education savings plans and prepaid tuition plans. Most education savings plans are available to everyone, but a few have residency requirements for the saver and/or beneficiary. Prepaid tuition plans typically have residency requirements. One exception is a prepaid tuition plan sponsored by a group of private colleges and universities.
The person who opens the 529 plan account is called the account holder or the saver. The person the account is opened for is called the beneficiary or the student. The account holder and the beneficiary can be the same person.
What are the differences between education savings plans and prepaid tuition plans?
Education Savings Plans. Education savings plans let a saver open an investment account to save for the beneficiary’s future qualified higher education expenses. Qualified higher education expenses include 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 for other education-related expenses. These include up to $10,000 per year per beneficiary for tuition at any public, private, or religious elementary or secondary school; certain expenses required for participation in registered apprenticeship programs; and qualified education loan repayments up to $10,000 total per beneficiary.
A saver may typically choose among a range of investment options, which often include various mutual fund and exchange-traded fund (ETF) investments and a principal-protected bank product. Education savings plans also may include static fund portfolios and age-based portfolios (sometimes called target-date portfolios). These portfolios include a combination of different types of ETFs and/or mutual funds and are designed to help diversify the risk in the account. Typically age-based portfolios automatically shift funds into more conservative investments as the beneficiary gets closer to college age, but static fund portfolios will keep the same mix of investments. 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 may not feel comfortable taking on riskier or more volatile investments if you plan on withdrawing the money soon. Therefore, 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, you can lose money in an education savings plan.
Prepaid Tuition Plans. Prepaid tuition plans let a saver or account holder purchase units or credits for the beneficiary to use in the future at participating colleges and universities. The saver is essentially pre-paying future tuition and mandatory fees at the current prices of tuition and mandatory fees. The participating colleges and universities are typically public, in-state institutions in the state that sponsors the plan. Prepaid tuition plans are not as flexible as education savings plans because the credits can only be used for future tuition and mandatory fees at certain schools. If the beneficiary does not attend a participating college or university, they can typically still receive money from the plan to help pay for college tuition and mandatory fees, but the amount is determined by the particular plan.
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, depending on how the plan calculates your return.
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.
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. 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.
Prepaid Tuition Plans. Prepaid tuition plans may charge an enrollment/application fee and ongoing administrative fees.
If you are interested in contributing to an education savings plan, be sure to research plans sponsored by states other than your state of residence. If an “out of state” plan has lower costs than your in-state plan, the cost savings may outweigh the benefits of the in-state plan, even when taking tax incentives (see below) or other benefits into consideration.
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 come with various restrictions or requirements. In addition, you 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 the other expenses detailed above, 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 these expenses, they will be subject to state and federal income taxes and an additional 10% federal tax penalty on earnings.
One exception is that you can rollover funds in a 529 account into a Roth IRA account for the same beneficiary. This could be helpful if you have money left over after your student finishes college. These rollovers have some restrictions. For example, the total rollover amount is limited to $35,000, annual Roth IRA contribution limits apply, the 529 account has to have been open for at least 15 years, and the funds you rollover must have been in the 529 account for at least five years.
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 you understand and are comfortable with any plan restrictions.
Investments. Education savings plans have certain pre-set investment options. It is not permitted to switch freely among the options. Under current tax law, an account holder is only permitted to change his or her investment option twice per year or when there is a change in the beneficiary.
Withdrawals. With limited exceptions, you can only withdraw money that you invest in an education savings plan without incurring taxes and penalties for qualified higher education expenses or the other expenses detailed above. One exception is that you can rollover funds in a 529 account into a Roth IRA account for the same beneficiary with some restrictions, which are explained above.
Beneficiaries of prepaid tuition plans may only use their purchased credits or units at participating colleges or universities. 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, depending on how the plan calculates your return.
Does investing in a 529 plan impact financial aid eligibility?
While different educational institutions treat assets held in a 529 account differently, investing in a 529 plan will generally impact a student’s eligibility to receive need-based financial aid for college. You may also need to consider how having money in your 529 account for future qualified higher education expenses might affect financial aid for your student’s elementary or secondary school tuition. Keep in mind, for many families, the larger part of a financial aid package may be in loans. So, the more you can save for school, the less debt you or your student may have to incur.
Where can I find more information?
Offering Circulars for 529 Plans. You can find out more about a particular 529 plan by reading its offering circular. The National Association of State Treasurers created the College Savings Plan Network, which provides links to most 529 plan websites.
Underlying Mutual Funds or Exchange-Traded Funds. Additional information about a mutual fund or ETF that is an investment option in an education savings plan is available in its prospectus, statement of additional information, and semiannual and annual shareholder reports. You can obtain these documents from the plan manager for no charge. You can also review these documents on the SEC’s EDGAR database.
Fees and Expenses. You can read about the impact fees and expenses have on your investment portfolios in the SEC’s Office of Investor Education and Advocacy’s Updated Investor Bulletin: How Fees and Expenses Affect Your Investment Portfolio.
Brokers or Investment Advisers. Many education savings plans’ program managers are registered investment advisers. You can search for an investment adviser and view the firm’s Form ADV or Relationship Summary by using the Check Out Your Investment Professional Tool on Investor.gov. You can also use the search tool to find out whether a broker who sells a 529 savings plan product is subject to disciplinary sanctions, information about their professional background and registration and licensing status, and their firm’s Relationship Summary. If you have questions about using the search tool, read our Investor Bulletin: How to Use the Investment Professional Search Tool.