Class Action: New Rules on College 529 Plans

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Congress and the White House are working on new proposals that would keep college 529 plan expenses down, widen the use of such funds and possibly even allow parents to do what was once unthinkable – cross state lines to get the best deals, while still getting favorable state tax benefits.

Stressed-out families of college-bound students could use all the help they can get. Fidelity Investment’s annual College Savings Indicator study says parents of children in high school, in particular, can only cover 11% of the total cost of their children's college education. That’s down from 15% in 2008, Fidelity reports. The study also points out that the cost of a college education continues to rise at 5.8% a year, with a total price tag of $124,400 for a high school senior in 2009.

The impetus for the scramble in Washington to shake up 529 plans is a September report from the U.S. Treasury Department. In it, Treasury analysts maintain that 529 plans could improve with a few new wrinkles, including more low-fee index funds, which would supplant actively-managed funds, thereby reducing fund management fees in the process. Right now, college 529 plans in 20 of 43 states only offer higher-priced actively-managed funds.

The Treasury plan would also target state tax benefit limitations in college 529 plans. Currently, families can’t take advantage of out-of-state tax benefits linked to 529 plans. Some states, like Pennsylvania and Missouri, allow for state tax breaks for out-of-state college plans. Right now, all states except Alabama do not tax Section 529 plan investment returns. According to the Treasury report, 43 of the 48 states offering a Section 529 savings plans are open to non-residents, meaning a particular beneficiary can have accounts in as many as 43 states.

But the state tax benefits part of the Treasury plan could backfire. With states bleeding cash due to the ongoing recession, some states may decide to eliminate state tax benefits related to 529 plans rather than have to pay out-of-state residents from a dwindling revenue supply.

It’s not just the Treasury that’s getting into the 529 act. The Internal Revenue Service has broadened its policy on 529 plans for 2009. Now, an investor who wants to make a change in his or her 529 portfolio can make tax-free changes in investment strategy twice annually. Before, investors could only make one tax-free change per year.

The move to revamp college 529 plans in the teeth of a recessionary gale still needs to find traction. But  to cash-strapped college-bound families, any forward motion at all is a step in the right direction.

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