Saving for College through Qualified Tuition (Section 529) Programs

Publication Date: October 2004

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Education

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Abstract:

Congress has tried to make higher education more affordable by providing favorable tax treatment to savings accumulated in qualified tuition programs (QTPs), also known as Section 529 programs. QTPs initially allowed individuals to save for qualified higher education expenses (QHEEs) at eligible institutions on a tax-deferred basis. With passage of P.L. 107-16, the benefit was enhanced temporarily by making qualified withdrawals from Section 529 programs tax free.

One type of QTP, prepaid tuition plans, enables account owners to make payments on behalf of student beneficiaries for a specified number of academic periods/course units at current prices thereby providing a hedge against tuition inflation. Only states were permitted to sponsor prepaid plans until P.L. 107-16 extended sponsorship to eligible higher education (private) institutions effective in 2002. Due to the impact of the 2001 recession on state government support for higher education and of the stock market downturn on plan performance, some statesponsored prepaid plans have been modified or closed.

States remain the sole sponsor of the more popular type of Section 529 program, college savings plans, which account for some 80% of the more than $51 billion in QTPs as of March 2004. College savings plans can be used toward a variety of QHEEs at any eligible institution regardless of which state sponsors the plan or where the beneficiary attends school. In contrast, if beneficiaries of state-sponsored prepaid plans attend out-of-state or private schools, the programs typically pay the same tuition that would have been paid to an eligible in-state public school. Also unlike prepaid plans, in which the state plan invests the pooled contributions with the intent of at least matching tuition inflation, college savings account owners can select from a range of investment portfolios. College savings plans thus offer the chance of greater returns than prepaid plans, but they also could prove more risky. Additionally, college savings plans charge fees (e.g., enrollment fees and underlying mutual fund fees) that lower returns -- more so for accounts opened through investment advisors (e.g., sales charges). The level of these fees vis-a-vis the tax savings, the extent and manner of disclosure across plans, and the role of federal regulators was the subject of oversight during the 108th Congress.

Both types of Section 529 programs have several features in common in addition to the above-mentioned federal tax treatment of qualified withdrawals. Account owners, rather than beneficiaries, maintain control over the funds. Contributions are not deductible on federal tax returns. A special gifting provision also allows a contributor to make five years worth of tax-free gifts in one year to a QTP beneficiary's account. Withdrawals used toward QHEEs must be coordinated with other higher education tax benefits. Assets in and income from QTPs may affect a student's eligibility for federal need-based financial aid. Earnings not applied toward QHEEs (e.g., the beneficiary forgoes college) generally are taxable and subject to a penalty. The tax and penalty can be avoided if account owners designate a new beneficiary who is a relative of the original beneficiary. This report will be updated as warranted.