529 Plans: A Summary

-Benjamin Franklin

Saving for education is one of the primary financial goals of mutual fund shareholders. Today, according to the U.S. Department of Education, more than half of all recent high school graduates in the United States pursue some type of postsecondary education, including professional, trade and business schools; junior colleges; community colleges; other two-year colleges; and four-year colleges and universities. While most parents today expect their children to receive a postsecondary education, research shows that only one-third say they expect to be adequately prepared to pay for their child's education.

Climbing College Costs Concern Parents

Since 1980, the cost of higher education has been rising between two and three times faster than the Consumer Price Index, according to the College Board. Over the past decade, public four-year college tuition and fees increased by 40 percent and private four-year college tuition and fees increased by 33 percent, according to the U.S. Department of Education. During the same period, median family income increased by 12 percent. Moreover, in recent years, federal financial aid for higher education has shifted largely toward loans and away from grants. As a result, the percentage of family income required to pay the cost of higher education has increased significantly.

Average Annual Higher Education Costs 2001-2002
(includes in-state tuition, fees, room and board)

School Type	Cost	Percent Change
Two-year public	$1,738	6 percent increase from 2000-2001
Two-year private	$13,231	5 percent increase from 2000-2001
Four-year public	$9,008	7 percent increase from 2000-2001
Four-year private	$23,578	5 percent increase from 2000-2001
Source: Annual Survey of Colleges, 2002, The College Board

Parents worry "nearly equally" about having enough savings for retirement and paying for higher education, according to a recent survey by Peter D. Hart Research Associates, Inc. The same research indicates that most parents expect to be "overwhelmed and unable" to pay all of the expenses for their children's higher education.

Helping Americans Prepare Financially for Higher Education

Recognizing the economic and social benefits of promoting education, federal and state lawmakers have developed a number of innovative programs to make higher education financially accessible to more Americans. In recent years, growing numbers of families are turning to one of these options, qualified tuition programs, as a way to help finance the higher education expenses of their children or grandchildren. These programs, commonly known as "529 plans" for the section of the tax code that authorizes them, are investment plans designed to pay for future qualified education expenses.

Two Types of 529 Plans

There are two types of 529 plans: prepaid tuition programs, which are set up to allow an individual to prepay a student's future tuition with today's dollars; and college savings plans, which allow individuals to contribute to an account established to pay a student's qualified higher education expenses at an eligible educational institution. Today, all states and the District of Columbia offer either prepaid tuition programs, college savings plans, or both.

College Savings Plans
Beginning in 1996, Congress authorized college savings plans to allow individuals to contribute to an account to pay a beneficiary's qualified education expenses, such as tuition, fees, books, supplies, and room and board. The value of college savings plans is based on the performance of the particular investments or investment strategy chosen by the contributor. As a result, college savings plans generally carry investment and market risks.

Contributions to college savings plans have been growing as the public becomes aware of their desirability as savings vehicles. Surveys of state plans indicate that assets held in 529 savings plans doubled from $8.5 billion at year-end 2001 to $18.5 billion at the end of 2002. The asset growth was mostly attributed to an increase in the number of accounts, which rose to nearly three million at year-end 2002. The average college savings plan account contains about $6,400.

Many mutual fund companies manage college savings plans for states, and mutual funds are the most commonly used investment vehicle in these plans. Each state's plan typically offers more than one investment option. These options typically include a variety of investment options, for example: a portfolio of stocks and bonds whose percent composition changes automatically as the beneficiary ages; a portfolio with fixed shares of stocks and bonds; or a portfolio with a guaranteed minimum rate of return.

529 College Savings Plan Growth, 1998-2002
(assets in billions of dollars)

Note: Data were estimated for a few individual state observations in order to construct a continuous time series.

Sources: Investment Company Institute and College Savings Plans Network

Prepaid Tuition Plans
These plans allow a parent, grandparent, or family friend to establish an account in the name of a student to cover the cost of a specified number of academic periods or course units in the future at either current prices or discounted current prices. While, to date, all existing prepaid plans have been state-sponsored and only permit the prepayment of tuition at colleges and universities within the sponsoring state, in 2003 the first privately sponsored 529 prepaid plan is expected to be offered to the public. This plan, offered by the Tuition Plan Consortium, expects to offer parents the opportunity to prepay tuition at a discounted rate at approximately 3000 private colleges and universities in the United States. A prepaid tuition plan account may be funded by lump sum or periodic cash payments. These programs, which provide a hedge against tuition inflation, enable the program sponsor to pool money and make long-range investments so that the earnings meet or exceed college tuition increases. As such, the program sponsor bears the risk that the earnings will, in fact, cover the cost of the education purchased by the account holder and the account holder is not entitled to recoup these earnings from the program sponsor. Instead, typically, the account owner is only entitled to obtain the education purchased through the account owner's principal in the event the account beneficiary does not utilize the account to pay for his or her higher education. The specifics of these programs vary greatly from one state to another, and state-sponsored programs differ from the Tuition Plan Consortium's Plan. Accordingly, an investor should consider his or her various options before investing in a particular plan.

529 Prepaid Tuition Plan Growth,1998-2002
(assets in billions of dollars)

Note: Data were estimated for a few individual state observations in order to construct a continuous time series.

Sources: Investment Company Institute and College Savings Plans Network

Tax Treatment of 529 Plan Contributions and Earnings

Contributions to 529 plans are made with after-tax dollars and earnings grow tax-free. However, as mentioned above, an investor in a prepaid program may not be entitled to these earnings. Earnings withdrawn from 529 plans to pay for qualified higher education expenses are free from federal income tax. State-tax treatment of college savings plan contributions and earnings varies from one state to another.

-National Savings Coalition

A number of states provide partial or full income tax deductions for contributions to the state's 529 plan. In addition, most states provide residents with a state tax break on earnings distributions from their state's 529 plans that are used to pay qualified in-state college expenses. These state tax advantages may or may not be available to investors who purchase a plan from another state or from the Tuition Plan Consortium. An investor should consider the state tax consequences of in-state, out-of-state plans, and private plans before investing.

For the latest legislative and regulatory developments concerning 529 plans and other related issues, return to the education savings index page. In addition, many mutual fund company websites offer information on education savings programs they offer. Individuals seeking additional information may want to visit the website for the College Savings Plans Network.

Additional Resources

• A Guide to Understanding 529 Plans (pdf)
• A Guide to Understanding 529 Plans (html)
• The College Savings Plans Network
• Tax Benefits for Higher Education, Internal Revenue Service

June 2002