Differences In 529 Plans | Why Saving For College Is So Messy

Why is saving for college so complicated? There are several different types of college savings plans, including 529 college savings plans, prepaid tuition plans, Coverdell Education Savings Accounts, and Child Savings Accounts (CSA). There are also non-education savings accounts, such as a Roth IRA. 

Choosing among the many options presents parents with a difficult choice. Generally, 529 college savings plans offer the best mix of tax, financial aid and estate planning advantages. But, even 529 plans are complicated. Almost every state has its own plan. And there are many differences in the 529 plans offered by each state.

Although the broad outlines of 529 college savings plans are defined by section 529 of the Internal Revenue Code of 1986, some states do not conform to all of the details of the federal law. Even when a state complies with the federal requirements, the state may have additional features that are not specified by the federal statute.

IRS rules specify the requirements for favorable federal tax and financial aid treatment of 529 college savings plans. These rules cannot specify the details of the state tax and financial aid treatment of 529 plans.

Many states provide special benefits for state residents for investing in the state’s own 529 plans. They also establish penalties for transferring the investment to an out-of-state 529 plan.

Two-thirds of states provide a state income tax deduction or state income tax credit based on contributions to the state’s 529 plan. Seven of these states provide the state tax break for contributions to any state’s 529 plan.

The limits on these state tax breaks differ by state. Not only do the contribution limits differ, but some states specify the limit per beneficiary and some per taxpayer. Excess contributions may be carried forward for a different number of years. Some states allow an inbound rollover from an out-of-state 529 plan to qualify for the state income tax break. But others limit the tax break to just the principal portion of the rollover.

Once the money is contributed to the state’s 529 plan, many of the states don’t want the money to leave the plan. They have adopted policies to prevent outbound rollovers to an out-of-state 529 plan. Some consider an outbound rollover to be a non-qualified distribution for state income tax purposes. Not only will the rollover be subject to state income taxes, but some states add a tax penalty. There may also be recapture of any state income tax breaks attributable to the rollover.

The Protecting Americans from Tax Hikes Act (PATH Act) added the purchase of a computer, peripheral equipment, internet access and computer software to the definition of qualified expenses, effective starting on January 1, 2015.

The Tax Cuts and Jobs Act of 2017 added up to $10,000 a year in tuition expenses at elementary and secondary schools to the definition of qualified expenses, effective January 1, 2018. The law also allows 529 plans to be rolled over into an ABLE account for a special needs beneficiary.

The Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) allows 529 plans to be used to repay up to $10,000 in student loans per borrower, tax-free, effective starting on January 1, 2019. The SECURE Act also allows 529 plans to pay for costs related to apprenticeship programs, such as fees, textbooks, supplies and equipment.

Some states automatically conform to changes in the federal definition of qualified expenses and some do not. The states that do not conform must pass laws to update their definitions. This has caused many differences in 529 plans in regard to how they define qualifying expenses.

Some states do not allow K-12 tuition, student loan repayment and apprenticeship programs as qualified expenses. Others are selective in deciding which changes to accept. Some have added K-12 tuition as a qualified expense, but not student loan repayment. Others limit K-12 tuition to in-state schools only.

The aggregate contribution limits vary by state, but all are large enough for most families. Minimum contributions also vary by 529 plan. Some allow minimum contributions as low as $15 or $25, but others require a minimum contribution of hundreds or thousands of dollars.

Some states provide seed money for 529 plans of newborn and newly adopted children. This is motivated by research showing that even a small 529 plan account can have a big impact on college enrollment and completion. The seed money for a new account may be $25, $50, $100 or $200, depending on the state.

Some states will match contributions for low-income families. The amount of the match may be limited. Other states require the family to set up automatic funding of contributions to qualify for the match. Certain states provide a bonus when the money is used to pay for college. Gifting platforms vary by state.

Perhaps the most important differences in 529 plans are related to cost and performance. Some states have higher asset-based expense ratios than others. Competition is driving down the costs in several states.

Direct-sold 529 plans do not charge commissions, but some advisor-sold plans do. Minimizing costs is the key to maximizing net returns.

The return on investment may vary depending on the investment options offered in each state. Some of the more common differences in investment options include:

When considering the tradeoff between lower fees in an out-of-state 529 plan and state income tax breaks for an in-state 529 plan, focus on lower fees when the child is young and state tax breaks when the child is in high school.

Some state 529 plans are open only to state residents, while others are marketed nationwide.
Some states will exclude money in an in-state 529 plan from consideration for eligibility for state financial aid funds. Others will make a student eligible for in-state tuition if they have invested in an in-state 529 plan, even if they no longer live in the state.

Although all 529 plans allow changes in the beneficiary to a member of the family of the current beneficiary, changes in the account owner are much more restrictive. Some allow a change in the account owner only if the current account owner dies. Others allow changes when the parents get divorced. Some charge a fee for a change in the account owner and some do not.

Most 529 plans provide online access. But three do not allow families to complete the enrollment process online. There may also be differences in the type of information that is available online and the number of available actions.