Named after the Section of the Internal Revenue Code that creates them, Section 529 plans are unique, tax-favored educational savings vehicles. Section 529 plans permit you to pre-fund up to five years of gifts (currently $60,000) per beneficiary, retain control over these assets, yet remove them from your estate for estate tax purposes.

There are two types of 529 plans: Prepaid Tuition Plans and the more popular Qualified Savings Plans. Prepaid Tuition Plans are typically limited to in-state public institutions and thus have limited planning application. Savings Plans, alternatively, have broad application in financial and estate planning. Savings plans are essentially state-sponsored mutual funds, because the account owner’s contributions and investment performance determine growth. Savings plans offer more flexibility and upside investment potential than prepaid tuition plans because they use a stock market investment approach. Numerous states have savings plans that are open to residents and non-residents alike.

With either type of 529 Plan, the owner contributes cash or cash equivalents (checks, money orders, credit cards, and similar methods) in exchange for interests in the 529 plan. Under current law, withdrawals are tax-exempt if used for “qualified higher education expenses” (QHEEs). QHEEs consist of tuition, fees, books, supplies, equipment, and a limited amount of room and board. Distributions for QHEEs from Private Savings Accounts (PSAs) from private post-secondary educational institutions are also excludable from gross income. With distributions for other than QHEEs, a portion of the distribution will be subject to taxation as coming from the earnings of the account.

It is important to note that the tax-exempt feature of 529 plan distributions is part of the 2001 Tax Act, which is scheduled to terminate at midnight on December 31, 2010. Therefore, unless Congress changes the current law, the prior law will once again control after December 31, 2010. Under the prior law, the earnings on 529 Plan contributions grew tax free until withdrawal, at which point they were taxed in the designated beneficiary’s tax bracket if used for QHEEs. If the owner or beneficiary withdrew funds for something other than qualified expenses, the original “distributee,” who is usually the account owner (parent or grandparent), would have been subject to income tax on the earnings portion of the withdrawal. In addition, most states impose a 10% penalty.