Introduction

Interviewer: Hello. I'm Gary Gamma. Welcome to our ongoing series on saving for college. Today, we're fortunate to have Joan Marshall join us by phone. Joan is chair of the College Savings Plans Network, a nonprofit organization that's affiliated with State Treasurers and is a leading voice in promoting college savings. She's also the executive director of the College Savings Plans of Maryland. Joan, thank you for taking the time to speak with us today about 529 plans.

Joan Marshall: It's a pleasure to join you, Gary.

Interviewer: Joan, many parents—like myself—and students today feel overwhelmed by the high costs of a college education. They believe that financing college is a major financial burden.

Joan Marshall: Gary, that's a very common sentiment. That's why I feel so strongly about the need to educate families about their options for saving for college. I believe that one of the most powerful tools for doing this is a 529 plan.

What is a 529 plan?

Interviewer: Joan, can you give us a simple definition of a 529 plan?

Joan Marshall: Sure, Gary. 529 plans are named after Section 529 of the Internal Revenue Code and are tax-advantaged savings plans generally sponsored by individual states. 529 plans allow anyone—parents, grandparents, even brothers and sisters, aunts and uncles, friends, and neighbors—to contribute to an account for a student, or the beneficiary. People can even open an account for themselves. There are two types of 529 plans: prepaid tuition, and savings or investment plans.

Prepaid tuition plans allow for the prepurchase of tuition based on today's rates and then pay out at the future cost when the beneficiary is in college. Performance is often based upon tuition increases, which—in percentage terms—often exceed the overall rate of inflation in the economy.

On the other hand, savings or investment plans are different, in that account earnings are based upon the market performance of the underlying investments, which typically consist of mutual funds. Keep in mind that investment returns are not guaranteed, and you could lose money by investing in a 529 plan. At this time, 48 states and Washington, D.C., offer such savings plans.

In general, 529 plans can be used toward eligible expenses when the beneficiary enrolls at an accredited undergraduate or graduate college or university, as well as certain trade and vocational schools. Because of a 529 plan's tax advantages, it could potentially offer greater growth than a taxable investment account.

Tax advantages of 529 plans

 Interviewer: Now, you said 529s have tax advantages. Can you tell us a little more about the benefits of setting up this type of plan?

Joan Marshall: Earnings on 529 plan accounts are free of federal and state taxes if used for qualified educational expenses as defined by the IRS to generally include tuition, fees, room and board, and books. In addition, many states allow a state income tax deduction for contributions. If funds are withdrawn and not used to pay for eligible higher-education expenses, though, then any earnings on withdrawals may be subject to federal, state, and local income taxes, plus a 10% federal penalty tax, and possibly a reversal of previous state tax deductions on contributions. This is known as a nonqualified withdrawal. The availability of state tax benefits may be contingent on meeting certain requirements.

Interviewer: Now, Joan, do I need to set up a 529 plan in the state I live in?

Joan Marshall: No, however, families are encouraged to consider the 529 plans offered by their home state and their beneficiary's home state, if it's different, since they may offer tax or other benefits that are not available with other plans. As the account holder, you can generally enroll in any state's 529 plan regardless of where you or your beneficiary lives. And regardless of which state plan you select, the beneficiary can attend any accredited school in the country that is eligible to accept federal financial aid. Finally, most states' prepaid tuition plans do have some form of residency requirement but are typically open when either the account holder or the beneficiary resides in-state.

Getting started with a 529 plan

Interviewer: OK, so once I choose a plan, what are the options as far as investment choices for 529s, and where can I set up an account?

Joan Marshall: Well, it's important to understand that 529 savings plans are municipal securities that invest in different types of underlying investments. Over the past 15 years or so, many mutual fund companies have become involved in managing investments for specific states' plans that often invest in their mutual funds. Many 529 savings plans offer easy-to-use "age-based" options that automatically adjust to become more conservatively invested as the student approaches college age. You may also be able to choose a portfolio that invests in an individual mutual fund or a combination of funds. Just keep in mind that this option does not automatically adjust as age-based portfolios do. Some 529 plans even offer portfolios that invest in FDIC-insured bank investments for very conservative investors.

Interviewer: Great, this is good information. Now, how much do I typically need to establish an account?

Joan Marshall: Well, Gary, the amount to start varies based on the plan you select. For some plans, it's as little as $15. Many plans also allow you to set up an automatic investment plan in which money is regularly withdrawn from your checking or savings account or through a payroll deduction plan. Keep in mind that automatic investment plans, though, do not ensure a profit or protect against losses in a declining market.

What are the ongoing costs?

Interviewer: Joan, are there any ongoing costs associated with holding an account?

Joan Marshall: Yes, Gary. The fees and expenses—including management costs—for 529 plans vary from plan to plan and among investment options. Basically, you can expect to have asset-based fees—such as underlying fund expenses, program management fees, and state fees—as well as an annual account maintenance fee, which is often waived for accounts that are funded with automatic contributions or for residents of the state sponsoring the 529 plan.

If you choose to invest in a 529 plan through an investment advisor, there may also be sales loads, which are commissions paid to your advisor for selling the college savings plan. You should carefully review the 529 plan's fees and expenses and the investment options you're considering before investing.

Can a 529 plan affect financial aid?

Interviewer: Does participation in a 529 plan affect a student's eligibility for financial aid?

Joan Marshall: Yes, it does, Gary, but not as much as some people may think. If the account owner is the parent of the beneficiary of a 529 plan account, the 529 plan is considered a "parental asset." As such, roughly 6% of its value is included in what's known as the "expected family contributions formula" when the student is considered for federal need-based financial aid. Keep in mind, though, that the way federal and nonfederal financial aid programs view 529 plan assets may change at any time. You may wish to consult a tax advisor for help with your specific situation. Also, families should check with the schools that their beneficiary is considering for details on their financial aid policies.

Interviewer: That sounds like great advice. Now what happens with the assets in a 529 plan if the beneficiary does not pursue higher education?

Joan Marshall: Well, there are several options. You, as an account owner, can keep the investment in the 529 plan; your beneficiary may choose to pursue higher education at a later date. However, at any time, the account holder can transfer the money to another member of the family of the original beneficiary—brothers, sisters, nieces or nephews, and so forth—without penalty. The less-desirable option is to withdraw the money and use it for whatever. Again, this is considered to be a nonqualified withdrawal and may be subject to federal, state, and local income taxes, and a 10% federal penalty tax on any earnings may apply.

How can I learn more?

Interviewer: Great, so this gives us a lot to think about. Joan, do you have any suggestions for where investors can learn more about 529 plans?

Joan Marshall: Yes, I do, especially because there are a number of helpful tools on the web. Your company's website, Vanguard.com, does a very nice job of describing the benefits of 529 plans. The "Find a 529" area of the site has a map that presents all state plans in a nutshell, and you have an opportunity to compare those plans, as well. Plus, you can link directly to any state plan's website. I also often recommend the College Savings Plans Network; their website is collegesavings.org.

Interviewer: Joan, you have given us a wealth of helpful information about 529 plans. Thanks again for your time today.

Joan Marshall: Thank you, Gary.

Narrator: For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing.

If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Vanguard Marketing Corporation serves as distributor and underwriter for some 529 plans.

Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.

When you invest in a 529 college savings plan, you are purchasing municipal securities whose value will vary with market conditions. Investment returns are not guaranteed, and you could lose money by investing in a 529 college savings plan. Account owners assume all investment risks as well as responsibility for any federal and state tax consequences.

Please note that neither Vanguard, nor any of its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

You may access and download this podcast only for your personal and noncommercial use. You may not use it in any other manner or for any other purpose without Vanguard's written permission.

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