A 529 Plan is a college savings plan that has federal tax advantages. Funds in the plan can grow free of federal income tax if used for payment of a beneficiary's qualified education expenses. Those expenses include tuition, fees, books, and room and board for undergraduate and graduate school.

From 1996 to 2001, Congress passed legislation creating and amending Section 529 of the Internal Revenue Code. Section 529 Plans are officially known as qualified tuition programs (QTPs) under federal law. (State income tax treatment may differ, so it is best to check the laws of your state.)

You can set up 529 Plans for yourself, your children, grandchildren, relatives, friends, or any other beneficiary who you would like to designate.

Two types of plans

There are two types of 529 plans: state savings plans and prepaid tuition plans.

State Savings Plans

State savings plans allow you to save money for college expenses in an individual investment account. The states appoint a financial institution to manage their plans and the accounts in them. To open an account, you contact the institution and fill out the appropriate paperwork. This includes naming a beneficiary for the account. Then you can start contributing.

Investment choices for your contributions are limited to the funds and portfolios offered by the plan. Usually, there are aggressive, conservative and age-based investment funds to fit your risk tolerance and the time horizon of the beneficiary.

When it's time for college, the beneficiary of the account can use the funds at any college in the country or foreign college (if approved by the U.S. Department of Education).

Prepaid Tuition Plans

Prepaid tuition plans allow you to prepay tuition to participating colleges for future use by the beneficiary. These plans can be offered by the states for their public colleges or by private colleges. The institution's investment manager invests the funds with the objective of keeping pace with the annual rate of college inflation.

There are two types of prepaid tuition plans: 1) a contract plan, in which the institution promises to pay a predetermined amount at a particular college in the plan, and 2) a unit plan, in which units, or credits, are purchased that represent a percentage of the yearly tuition costs of that college.

How much can be contributed to a 529 plan?

Section 529 requires that contributions cannot exceed the amount necessary to cover the qualified college education expenses of the account beneficiary. This amount is usually five years of qualified expenses at the most costly college allowed. Each plan can set its own limits. The maximum lifetime contribution is chosen by the states and is at least $250,000 in most states.

The lifetime limit for the plan is a per-beneficiary limit, not a contributor limit. So if you and your parents open 529 accounts for your son, the total contribution for all of you would be $250,000. This works in your favor if more than one child will attend college because a separate 529 account can be set up in the same way for each child.

By Norm Langlois, CFP®