What You Need to Know Before You Invest in a State 529 Plan

A State 529 plan, named after section 529 of the Internal Revenue Code, is designed to encourage saving for future college expenses for named beneficiaries. Although investors are sometimes allowed to contribute to these from out of state, there are significant advantages for investors to use their own state's plan, such as tax advantages, matching grant and scholarships, protection from creditors, and exemption from financial aid income qualifications.

Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, distributions from these special educational savings plans are exempt from federal income tax.

The two types of 529 plans are prepaid and savings. Prepaid plans, administered by the states themselves or by higher education institutions, allow you to purchase tuition credits at todays rates to be used in the future. Savings plans, administered by the states, offer investment vehicles, mostly in the form of mutual finds. Their growth is therefore based on market performance, so you will want to choose one that has a comfortable level of risk.

There are a few disadvantages to these plans that you should be aware of up front. First of all, some carry excessive fees that serve to negate the plan's tax benefits. Also, money withdrawn from a 529 plan that is not used for eligible college expenses will be subject to income tax. The earnings portion of the withdrawal will also be subject to an additional 10% federal tax penalty.

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