In 2005, annual tuition costs at four-year public universities rose 7.1% to $5,491, while tuition at private colleges and universities rose a similarly significant and 5.9%, to $21,235. But tuition is just part of the pie. When you add in room and board, students pay an average $12,127 for one year at a public school and $29,026 if they choose a private institution.

That’s a significant outlay, and most students find themselves in need of financial aid at some point in their education. Many parents scrimp and save – and often put off saving for their own retirement, just so their children can go to college. Now that’s a subject for another issue of Financially Fit, but today, I’d like to talk about the 529 Plan, the college-funding investment that has experienced explosive growth in the last few years, with more to come in light of recent favorable federal regulation.

What is a 529 Plan?

Born in the 1980s as a vehicle to save for college tuition, the plan became part of Section 529 of the Internal Revenue Code in 1996.

But the 529 really took off when the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made qualified distributions exempt from income tax. Additional elements of the Act enlarged the definition of family members to whom a 529 beneficiary might be changed, and also allowed colleges, or a consortium of colleges, to sponsor 529 plans. Today, distributions of 529 plans may be used at more than 8,000 schools in the U.S. and more than 800 international higher education institutions.

And while those provisions were fabulous, there was a clincher. The Act included a sunset clause, which provided for expiration of the tax measures in January 2011. Not anymore! As of last month, the Pension Protection Act of 2006 made the federal income tax exclusion on qualified withdrawals permanent, meaning continued expansive growth of 529’s is right around the corner.

529 Plans are operated by the individual states to assist families with savings for future college costs. It is each state’s decision as to whether it will offer a plan and what benefits and options the plan will contain. Every state has at least one 529 plan available.

529’s come in two flavors:

Prepaid
Prepaid plans are offered by states and educational institutions, many only to in-state residents. Investors purchase tuition credits in prepaid plans – quarters, semesters, or years of tuition, that are then guaranteed for the future – irregardless of whatever tuition hikes occur between time of purchase and time of use. Prepaid plans generally cover in-state tuitions, but many will allow transferal of the contract to out-of-state schools, although one may not receive full value.

These plans will often are limit enrollment to certain ages or grade levels. And they typically charge enrollment and administrative fees.

The performance of prepaid plans is based on tuition inflation, not investment performance, making them ‘safer’ and attractive to conservative investors. They would be more suitable for children who don’t have a tremendous number of years prior to going to college, maybe, 3-7 years from enrollment in the plan.

Savings
529 Savings Plans are sponsored by the individual states, but not by educational institutions. Most have no state residency requirements.

The growth of 529 Savings Plans is based upon the market performance of the underlying investments in the plan. They may include stock mutual funds, bond mutual funds, money market funds, and certificates of deposit. Most plans will offer a range of age-based asset allocation portfolios, becoming more conservative as your child nears college age.

They may also offer risk-based asset allocations, keeping a fixed percentage in fixed-income versus equity regardless of the beneficiary’s age. Others are designed with a stable value or guaranteed option whose goal is to protect the account principal while offering some investment growth.

Savings plans can generally be used at any U.S. college or university and some international institutions. They are not guaranteed by the states and are not federally-insured. And unlike most prepaid plans, they have no age limits, are open to adults and children and enrollment is usually open all year. However, switching among investment options is usually limited, often to once a year.

These plans may charge enrollment fees, sales loads (broker commissions) , annual maintenance fees, annual distribution fees (similar to the 12b-1 fees at mutual funds, and average between .25% and 1.0% of your investment) and asset management fees (which may be waived or reduced, depending on size of the account or if contributions are automatic) .

529 plans offer numerous advantages, including numerous tax breaks, owner-control of the accounts, no income limitations, and ability to make large contributions. Next week, I will cover each of these benefits in detail and also provide you with a list of questions you should ask prior to committing to a plan, as well as several resources to help you in finding the best plan for your family.

Until then, happy investing…