Qualified tuition plans -- also known as 529 plans, named after the section of the Internal Revenue Code that governs them -- are financial accounts designed to provide a tax-advantaged way to save for college. There are the two types of 529 plans: college savings plans and prepaid tuition plans. States sponsor most 529 plans, and each plan has its own contribution limits. However, in general, states maintain very high ceilings for 529 plans so that investors are not prevented from saving sufficient funds to cover college costs. A 529 plan allows contributions from both the plan account holder and any other individuals.
Although contribution limits vary among different 529 plans, each must follow the overriding IRS edict that contributions cannot exceed the funds needed to pay for qualified college expenses for the beneficiary. College savings plans and prepaid tuition plans have different definitions of "qualified expenses." Funds in college savings plans, which are investment accounts, can be used for tuition, room and board, mandatory fees and required equipment, such as textbooks. Prepaid tuition plans allow account holders to pay only tuition and mandatory fees, locking in rates years before the beneficiary attends college. Contribution limits are treated differently with the different plans, too. Prepaid tuition plans place limits on contributions into the account. College savings plans, however, also take into account earnings, so that the limit is triggered by the total value of the account, not just what you paid into it.
Since costs vary among colleges, states can set their limits based on the maximum possible expenses for the highest-priced college in their plan. They also sometimes include the cost of graduate school. Prepaid tuition plans typically have a limited number of eligible colleges in their plans, such as public colleges and universities in that state, whereas college savings plans include a much wider selection of colleges stretching nationwide. Many states currently have contribution limits of more than $300,000 and adjust their limits annually to keep pace with growing college costs.
The IRS does not impose annual contribution limits on 529 plans for either a single contributor or an entire account beyond the maximum overall limit guidelines. However, states might set an annual limit. The IRS notes that large contributions to a 529 plan can have tax consequences in a given year. In particular, contributions by a single individual that exceed $13,000 in a single year might trigger a federal gift tax for the contributor -- although some exceptions to that rule may exist, too, depending on your circumstances.
Receiving distributions from a 529 plan to pay for qualified college expenses is tax-free, but withdrawing funds from a 529 plan for anything other than qualified college costs carries a tax impact. In particular, the account holder or beneficiary, depending on who receives the money, must pay income tax on the withdrawal and an additional 10 percent tax penalty. However, the 529 plan offers a level of flexibility that allows an account holder to avoid paying taxes and penalties if the designated beneficiary does not ultimately need all of the funds in the account for college expenses. Account holders simply can replace the designated beneficiary with a new one. This transfer of beneficiaries can occur without a penalty or charge to the account holder.
- Internal Revenue Service: Tax Benefits for Education
- Internal Revenue Service: 529 Plans - Questions and Answers
- USA Today: Money in a 529 College Saving Plan is Flexible, To a Point
- Peterson's: The Pros and Cons of Using a 529 Plan to Save for College
- Securities and Exchange Commission: An Introduction to 529 Plans
- College Student image by Jaimie Duplass from Fotolia.com