There’s no such thing as a dumb question, but asking questions seems to make plenty of people– myself included– feel dumb, which then causes us not to do it. For those who find themselves wishing they had asked more about 529 plans, here is a “back to basics” guide. (As an aside, there is a veritable alphabet soup of college savings options including UGMA/UTMA accounts, Coverdell ESAs, and more. For most people, 529s are the best option so I’m talking about them first. I’ll cover the others later.)

First, a 529 plan is a tax-advantaged college savings plan operated by a state or educational institution. 529 refers to Section 529 of the IRS code which created these plans beginning in 1996.

529 plans offer several types of tax advantages:

  • Funds in the accounts grow tax-free
  • As long as they are withdrawn for qualified expenses– generally tuition, room, board and certain supplies– the withdrawals are also tax-free
  • Many states also offer their residents a tax deduction for investing in the state’s 529 plan. For example, Oregon offers a tax deduction for the first approximately $4,500 (married filing joint) or $2,250 (single filer) in contributions each year.

Beyond the tax benefits, there are some other benefits in financial aid equations. On the one hand, money in a 529 account is treated the same as a taxable brokerage account in the aid formulas– it’s assessed as a parental asset and, if the balance is greater than the asset protection allowance, it’s assessed at a rate of 5.65%. But there’s a big difference when you actually withdraw and spend the money: Besides the 529 plan’s growth not being taxable, withdrawals from 529 plans don’t count as income when you fill out next year’s aid forms. What does that mean? Let’s suppose you withdraw $20,000 from your brokerage account in 2013 to pay for freshman year, and that withdrawal included $5,000 in capital gains. That $5,000 will show up on your tax return, so you’ll pay taxes on it. Not only that, but the gain will also show up as income on your FAFSA or CSS PROFILE, which means it will be assessed at your highest income assessment rate, probably 47%, translating into an additional $2,350 in EFC. (Of course, if you had a loss in the brokerage account, it would have the opposite effect.)

Nearly every state offers a plan, and you can choose any state’s plan to invest in. Whichever plan you choose, you can use the funds at any qualified higher education institution. For example, you can live in Oregon, invest in Virginia’s plan, and send your student to college in California.

There are two types of 529 plans:

  • Savings Plans work a lot like an IRA or 401(k): you choose what to contribute and how to invest it. Your account balance will fluctuate based on your contributions and market performance.
  • Prepaid Plans let you prepay your state’s public school tuition, essentially locking in today’s tuition rates. Generally they also let you convert your savings to use at a private or out-of-state institution. Typically you purchase “units” of college tuition at today’s price (a “unit” might equal 1/100th of the cost of one year’s tuition); those units maintain their relative value as tuition increases.

Savings Plans are far more common than Prepaid Plans.

I’ve said “qualified” a few times here, and since you’re not a question-asker, I probably should tell you what that means too. With a 529 Savings Plan, “Qualified expenses” include tuition, mandatory fees, room and board, textbooks, supplies and other equipment that is required for enrollment. Prepaid plans cover a smaller list; check the plan’s document for details. One potentially significant expense that is not “qualified” is the cost of getting to and from school. Computers may or may not be qualified. Student loan payments and entertainment (sports tickets, fraternity/sorority dues, etc.) are also not qualified.

Qualified institutions are those for which you can withdraw funds tax- and penalty-free to pay for qualified expenses. A list is available here— and note, the list is not limited to US institutions.

Later we’ll get into the details of choosing a plan and opening an account.