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The Four-One-One On 529s

Congress handed families a gift this year by allowing them to save money for college tax-free through a plan called 529. However, understanding the plan's restrictions and choosing one that's right for you can be a headache. The Saturday Early Show Personal Finance Contributor Ray Martin has the 411 on 529.

Make no mistake. Changes in the tax law this year makes 529s an amazing investment option for most families planning to send children to college.

As their popularity grows, investment companies are spewing out a slew of different 529s, all with different rules and benefits. This spells confusion for most investors.

Large employers such as Ford Motor Company are already offering 529s as part of employee benefit packages. This trend promises to continue, and employees must be able to make educated decisions.

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Here are some frequently asked questions, answered by Martin.

HOW POPULAR ARE 529 PLANS?
At the beginning of 2001, there was $2.5 billion invested in 529s. By the end of the year, that number had jumped to an estimated $10 billion. (That's a 400 percent increase!) Financial advisers predict that companies offering 529s to employees will soon make the plans as popular as the 401k.

WHAT IS A 529 SAVINGS PLAN?
An investment vehicle that allows individuals to save money for secondary education (named after the section of the IRS code authorizing the plan). Contributions are made after taxes, but the money is allowed to grow tax deferred. The best part is that if the money is used for college expenses, it never incurs a tax.

HOW DOES THE PLAN WORK?
The plans are similar to mutual fund investments. You simply make a contribution. It's invested for you and grows over time.

HOW MANY PLANS ARE THERE?
Here's where things get a bit tricky. 529s are state-sponsored. That means each state has its own plan, complete with its own contribution limits, tax benefits, fees and other regulations. Currently, 42 states offer 529s and most of the others should launch plans by year's end.

Adding to the confusion, almost all states have at least three different 529 plans. The number of savings plans continues to grow as states seek to provide a variety of choices and maximum flexibility to investors. And investors don't have to use the plan offered by their state; they can choose any state's plan that suits their needs.

WHO CAN INVEST IN A 529?
Anyone can open a 529. Once a savings plan is opened in a beneficiary's name, anyone can contribute money to it. Although the beneficiary is typically a child, adults planning to go back to school also can establish their own account. While money in the 529 may be earmarked for a child, that child does not have control over the money, even when he turns 18 or 21. The plan's owner always has ultimate control.

The plan's owner also has the ability to change the beneficiary. If one child doesn't go to college, the fund can be transferred into another child's name. Or, an individual can set up a 529 in her own name before even having children. Once a child is born, he can become the beneficiary of that 529.

ARE THERE CONTRIBUTION LIMITS?
Yes. But, as mentioned above, they differ from state to state. The limit can be as high as $270,000. Once an account reaches this limit, you must stop all contributions. However, the money will still be allowed to grow beyond this amount.

It's also interesting to note that you could open a 529 in every state, if you wished. (That's a lot of money!) Certified public accountant Joseph Hurley is a recognized expert on 529s. In an article in the Providence Journal-Bulletin, he said that he and his wife have accounts in 23 different states.

WHAT HAPPENS IF YOU DON'T USE THE 529 FOR COLLEGE?
You pay traditional income tax on the earnings and an additional 10 percent penalty. Remember, if the beneficiary does not attend college, you can roll the money over into an account for another family member at no fee.

529 DRAWBACKS
The biggest unanswered question about 529s has to do with financial aid. 529 assets probably will decrease the amount of financial aid for which a family is eligible. However, since the recent tax changes, details remain up in the air.

Some people also bemoan a certain lack of control over their investment. Once you choose a 529 plan, you must leave the money where it is for one year. At that time, if you are unhappy with your returns or want to pursue a different strategy, you can move to a new 529.

Another complaint voiced by some is the lack of a track record for 529s. As young funds, the 529s have a short investment history. This makes it difficult to compare their performances.

None of these objections outweigh the advantage of growing your money tax-free.

CHOOSING A 529 PLAN

  • Consider your strategy. First, you need to determine your savings goal and how much time you have to reach that goal. Then, you can choose a more aggressive or conservative investment strategy.
  • Look for tax benefits. All 529s allow money to grow tax-free. But there's another benefit out there: 23 states allow investors to deduct contributions from state income taxes. In New York, you can deduct up to $5,000, in Mississippi it's $10,000, and in Colorado and New Mexico, you can deduct every penny. You must live or work in some states to receive their deductions.

    Keep in mind that while the fed won't tax earnings, a state might; when it comes time to use your savings for college, some states tax that withdrawal. Another tax pitfall: six states tax residents who invest in an out-of-state plan.

  • Compare plan fees. Like mutual funds, 529 plans may charge a set-up fee, a yearly fee and/or a percentage of assets. Investing through a broker can add an additional fee.

    While we're discussing brokers, investors need to be aware that some plans pay a commission fee. Make sure your broker is recommending what's best for you, not what's best for his pocketbook.

    Once you educate yourself about 529s, there's no need to use a broker to establish the plan. Contact your state treasurer directly or log onto the state's web site. Also check out savingforcollege.com. The site is a complete primer on the subject, compares state plans and provides state contact info.

529s AS A PAYROLL DEDUCTION
Opportunities to invest in a 529 through an employer will continue to grow. Like saving for retirement through a 401k, this benefit option is easy and convenient. However, make sure the 529 your employer offers makes sense for you. Consider your investment strategy, look for tax benefits and compare plan fees.

WHAT IS UPROMISE.COM AND IS IT WORTHWHILE?
Upromise.com is a Web site that allows investors to accumulate money for their 529 through shopping. The site has a variety of partners such as Toys R' Us, GM, and Coca-Cola. When you spend money with these companies, a percentage of what you've spent is placed in a upromise.com account. (You must sign up online to establish the upromise.com account) The money is then transferred to your 529 plan.

This is not a scam, and there are no fees involved. However, the money earned can be compared to frequent flyer miles: it takes a long time to accumulate enough to make a difference.

OVERALL, ARE 529S A GOOD CHOICE FOR YOU?
It doesn't make sense to open a 529 if you plan to use the money within five years. The money needs at least five years to grow. Otherwise, go for it!

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