Managing Your 529 College-Savings Plan

So you've decided to go with a 529 college-savings plan, and you've narrowed it down to the one that best fits your needs. Congratulations! You've tackled the hardest part of the 529 college-savings process. But how do you go from where you are now to generating tax-advantaged distributions? If you're working with a broker, he or she should guide you through the savings process (the advisor's guidance is what you're paying the broker fees for, after all). For those going it alone, this article walks you through the next steps, including opening a 529 account, maintaining it, and withdrawing assets.

First Things First
Direct investors first need to fill out the application, which can be found on the 529 Web site (we list Web site addresses on our 529 plan summary pages, found here). The application will ask you basic information about yourself, your beneficiary, your investment choices, and your contribution method. Let's stop here for a moment. Contribution methods range from sporadic payments to automatic deposits, either from your bank account or your paycheck. If your goal is flexibility, you might be tempted by the sporadic payment option, but many investors benefit from the discipline imposed by the automatic options. If you aren't forced to contribute on a regular basis, you might find yourself sidetracked from your college-savings goals by short-term concerns. And if you're eligible for state-tax deductions on your 529 contribution, payroll deductions mean you don't have to wait for an annual refund; the adjustment will be made at the time of the contribution.

While there's no limit to how much you contribute to a 529 plan annually, gift taxes can apply, depending on your relationship with the beneficiary and the amount you contribute in any given year. In 2008, you can give up to $12,000 ($24,000 for joint filers) to any individual without triggering gift tax. College savers can also make a $60,000 ($120,000 for joint filers) contribution to a child's 529 in a single year--essentially five years' worth of gifts--without triggering the tax, presuming they make no further contributions during that five-year period.

Also, most 529 college-savings plans have a cap on account size. If that's a concern, investors can open up another college-savings account elsewhere to house additional funds, but college savers are taxed and penalized on what they don't use for secondary education expenses. Overall, it makes sense to plan your contributions judiciously and consider how long it will take you to reach your goals so you can keep the taxes and penalties to a minimum.

Monitoring Your Choice
After you've submitted the application and planned your contribution method, you're in the game. But that doesn't mean you can forget about your 529 college-savings plan. All 529 college-savings plans allow you to change your investment choices once a year, and it's important to check in with your plan at least that frequently (even if you've chosen the age-based option, which is designed to grow more conservative as college draws near). The overall plan isn't static, because taxes, fees, and even investment options often change, and neither are the underlying funds. Managers come and go, strategies evolve, and expenses rise and fall. You may find that the features you initially liked about a particular fund or collection of funds are no longer there.

Also, if you've chosen a static allocation with a fixed mix of equity and/or fixed-income mutual funds, you'll likely want to grow more conservative over time. For instance, when the beneficiary is still five to 10 years away from college, it makes sense to invest heavily in equity mutual funds, with healthy stakes in international and small-cap stocks, in hopes of growing your principal. In the years before college, however, it's typically wise to stick mostly with fixed income. Bonds are less likely to earn monster returns, but their muted volatility will generally better protect your assets at a time when you don't have long to make up any losses.

In all, while you don't want to chase performance (which rarely turns out well) or change your investments willy-nilly, it pays to consider whether you should make an adjustment given new information.

In the Event of...
Remember, college-savings plans are designated for postsecondary education, and using the assets stored there for nearly anything else will invoke taxes and a penalty. This is true even for emergencies. If your beneficiary foregoes college and you can't find another beneficiary to name, you are stuck with federal and state tax bills on the investment earnings, a state-tax bill on deducted contributions, and a 10% penalty. The same is true if you've faced financial setbacks and need the 529 assets for other concerns. The only exceptions involve either tragedy or financial aid. Any distributions resulting from the beneficiary's untimely death or severe disability trigger taxes, but the penalty is waived. The same holds for financial aid: If the beneficiary earns a full scholarship or gains another type of financial aid, the investment-earnings component of the distributions made to the beneficiary are still taxable but not penalized. (Whether you are taxed at your rate or the beneficiary's rate depends on the circumstances. Keep this general rule of thumb in mind: If the distributions are to or for the benefit of the beneficiary, you'll be taxed at the beneficiary's tax rate.)

Distribution Time
When you've finally reached the point when you call on your 529 assets, there's more to consider. To ensure the tax benefit and to avoid the penalty, the distributions must cover qualified education expenses, such as tuition and room and board. At this point, any nonqualifying distributions result in tax consequences for the beneficiary, not the account owner. So plan carefully. Be sure to custom-fit the distributions to the expenses you're facing and keep a paper trail of what you've paid with what distributions. You'll have to report the distributions on Form 1099-Q when you file taxes.

Also, don't forget about the impact on financial aid. Because 529 college-savings plans are considered the account owner's assets and not the beneficiary's, they don't have a major impact on financial aid. However, nonqualified distributions to the beneficiary will not only require the beneficiary to pay taxes, they may also be penalized with reduced need-based awards in later years.

Wrapping It All Up
Overall, 529 college-savings plans have plenty of advantages, but they do require upkeep. Make sure you understand your financial situation and the nature of your investments. That will allow you to manage your distributions and also help you to monitor your 529 plan along the way.