New Law Gives 529 Plans Permanent Tax-Exempt Status

Before members of Congress left for their summer break, they gave parents, grandparents, aunts, uncles and anyone trying to save for a child’s college education a welcome break.

Included in the Pension Protection Act, passed by the House and Senate and expected to be signed by the president, was a provision to give permanent tax-exempt status to 529 college savings plans.

This is a significant development for plans intended to help pay for the ever-escalating cost of a college education.

The 529 plans many people invest in now weren’t always so tax-friendly. Prior to 2002, if you invested in a 529, earnings grew tax-deferred and when the money was withdrawn it was taxed at a child’s rate.

But thanks to another law passed in 2001 and which took effect in 2002, state-sponsored 529 plans gained federal tax-exempt status. The change allowed contributions to grow tax-free and earnings became sheltered from federal taxes as long as the money is used to pay for qualified higher education expenses.

This favorable tax treatment was scheduled to expire on Dec. 31, 2010. Had it expired, the tax benefit would have returned to what it was before 2002.

A 529 plan operates much the same way 401(k) retirement savings plans do. States, like employers, arrange for an investment company to set up and manage their 529 savings plans. Each plan can have a number of investment options.

There are two types of 529 plans: prepaid tuition plans and savings plans. A prepaid tuition plan allows people to pay a child’s tuition in advance. The more popular savings plan allows people to invest in a tax-free investment account.

Although the 529 plans are sponsored by states, you can invest in any plan regardless of where you live. And money invested in a 529 plan can be used for a state or private institution.

Before the tax-free benefit, states and financial advisers were having a tough time selling this investment vehicle. By 2001, $5.77 billion had been invested in 529 plans across the country.

Since the change in the tax status of these accounts, an additional $74.4 billion has been added, according to Chris Hunter, program manager at the College Savings Plan Network.

Still, 529 account sales would have been even higher without the threat that the tax-exempt status would sunset in 2010, says David Pearlman, chairman of the College Savings Foundation, a Washington, D.C.,-based non-profit organization.

“I think definitely people were taking a wait-and-see attitude,” Pearlman said.

In an online poll taken by Joseph Hurley, founder and CEO of SavingforCollege.com, 51 percent of respondents said they would put more money into 529 plans if the tax-exempt treatment was made permanent.

“I believe that making the 529 tax status permanent is the single most important development affecting college savings since the 2001 tax act first gave us the tax exemption,” Hurley said. “I believe that sales of 529 plans will increase dramatically as a result.”

Every state and the District of Columbia now offer at least one 529 plan. Let me save you some time. The College Savings Plan Network (www.collegesavings.org) provides links to each state’s 529 plan Web site with nuggets of details about what plans each state offers.

Like any investment, there’s much to know about these plans, so invest with caution. For instance, watch out for fees. College savings plans are sold to investors either directly by the state-sponsored plan or via an investment adviser, brokerage firm or bank. Broker- and adviser-sold plans often contain sales loads and higher fees and expenses than direct-sold plans, according to NASD, the private-sector regulator of the securities industry.

NASD has an excellent section on its Web site about investing for college, including a tool that helps you compare fees and expenses. Go to www.finra.org and click on the link for “Investor Information.” Then click on the link for “College Savings Center” and then “Expense Analyzer.”

NASD’s analyzer requires some work because you have to input fee and expense information. If you don’t have time to hunt through 529 plan brochures or disclosure statements, then use Hurley’s “529 Evaluator” at www.savingforcollege.com. You can compare up to six plans at a time side-by-side, and the expense and fee information is provided.

There’s something else to consider before investing in a 529 plan. Check to see if your home state offers a state tax break. For example, if you’re a Connecticut resident and you invest in the state’s 529 savings plan, you can get a state income tax deduction of up to $5,000 ($10,000 for married couples filing jointly).

I was a fan of the 529 savings vehicle even when it wasn’t a sure thing that it would retain tax-exempt status. Now there’s no question this should be an essential part of your college investment plan.

By Michelle Singletary