Section 529 college savings plans are accounts sponsored by states (or state agencies) or educational institutions. Authorized by section 529 of the Internal Revenue Code (hence the name), the plans allow the holder, whether it’s the student, the parent or someone else, to put away money into an interest (or other type of earnings) bearing account and then withdraw the money tax-free — as long as the funds are used to pay for qualified college expenses. The nature of the accounts and how they earn income vary by the sponsoring agency or school.

Types of 529 Plans

Section 529 of the Internal Revenue Code provides for two basic types of plans: college savings plans and plans under which you pre-pay tuition at a set rate that is often protected against future increases. Each of the states, as well as the District of Columbia, offers at least one of the 529 plan types (some offer both), while a number of private schools also sponsor pre-paid tuition plans. There are certainly advantages to each type of plan, and both plans directly affect a student’s eligibility, as well as need, for financial aid.

The most-used of the two types of 529 accounts are the college savings plans. Under a college savings plan, the account holder (or owner) sets up an account on behalf of a beneficiary — the student — in order to save up for future payment of college expenses. Under the state-sponsored plans, the account holder is generally given a limited selection of investment options and vehicles from which to choose. The plan — or its administrator, as many states farm out the investment and management of the fund to brokerage houses or investment firms — then invests the contributions on behalf of the account holder. Typically, the investments tend toward the more fiscally conservative in order to minimize risk to the college funds. Mutual funds, of both the stock and bond varieties, money market funds and age-based investments that become more and more conservative as the student approaches college age are among the most common investments made with funds in section 529 plan accounts.

When it is time for the plan beneficiary (the student) to start school, withdrawals can be made from the account and used at most any college or university to cover tuition and a handful of other acceptable education expenses. The beauty of the program is that such withdrawals are tax free, so the the gains accrued over the years will be fully applied to college expenses. A word of caution, though: section 529 plans that invest in mutual funds, or other securities, are not insured by the federal government nor are they guaranteed by the state sponsors. Thus, it is possible (as many college savers saw in 2008 and 2009) to lose money in your section 529 college savings plan, just as it is in any other investment account.

A safer, but considerably more limited, option is a section 529 prepaid tuition plan. Under the pre-paid tuition plan, you generally lock in a tuition rate, as well as a specific school or set of schools (like a state’s university system). While a few prepaid tuition programs are sponsored by individual colleges, the majority are sponsored by states themselves. The investments are often guaranteed but typically require residency in the state for participation in the plan.

The way most prepaid plans work is that your contributions are used to purchase credits toward future tuition. So, if your student is currently 8 years old, your 529 contribution would buy college credits in today’s dollars for an education a decade in the future. Not a bad deal if you can all agree on college years ahead of time. This is the limiting factor. Moreover, not all states sponsor such plans, so even if you are interested, you may not be eligible to participate in a prepaid tuition plan unless you choose a specific private college that offers a section 529 option. SAGE Scholars is a good place to get some ideas of what colleges out there offer such plans, or to even get started through the SAGE program, itself, which is similar to a 529 option.

One last consideration for section 529 plans is how they affect financial aid eligibility. As great as they are, they can be problematic for families that will still need some form of aid in addition to their 529 savings. In the next post, we will look at some strategies to maximize both your 529 plan effectiveness and financial aid eligibility.