Head off college debt: 529 plans to the rescue

For people already facing massive payments on student-loan debt, Section-529 college savings plans won't help. But for students and prospective students with more time to prepare, these tax-sheltered accounts can work nicely.

In recent years, many students, or their parents, have resorted mainly to borrowing to pay for college. At $1.2 trillion, student loans now rank as the second-biggest type of consumer debt, behind only mortgages, reports the Federal Reserve Bank of New York.

But that also means sizable loan payments await, and not all graduates or dropouts have been able to handle their obligations. Student-loan delinquencies have been rising, and this type of debt generally can't be discharged in bankruptcy. Many borrowers undoubtedly wish they, or relatives, had started investment accounts instead.

Section-529 plans are a potential solution, at least for students, parents, grandparents or others with time to let the accounts grow for many years.

Tax-free bonus

One key advantage of 529 accounts, named after a section of the Internal Revenue Code, is that investment earnings grow sheltered and can be withdrawn free of federal taxes if proceeds are used for higher-education costs, including room and board.

Withdrawals also typically avoid state income taxes, and most states offer an added incentive in the form of a state-tax deduction (there's no federal deduction). Many states require that residents attend an in-state college to get this deduction but some, including Arizona, allow it even for students who attend college elsewhere. Arizona's deduction is worth up to $2,000 for individuals or $4,000 for married couples.

Several states do even better on the tax front. For example, Connecticut, Illinois, Michigan and New York allow deductions in the $5,000/$10,000 range, while Illinois and Oklahoma double those amounts. Colorado allows residents to deduct contributions up to the extent of their taxable state income and, in some years, has provided matching funds for modest-income residents.

Even though there's no federal deduction on 529 contributions, President Obama caused a scare earlier this year when he proposed to end tax-free withdrawals for wealthier families, but that idea appears to have fizzled.

The accounts are flexible in many ways. For example, if money isn't used for higher education — if a youngster skips college or, alternatively, receives a full-ride scholarship — the money can be used for the educational needs of other relatives or even withdrawn by the person who funded the account. (Taxes and a 10% penalty on earnings could apply in some scenarios.)

There's also flexibility in terms of choices. Nearly all states offer 529 programs in partnership with investment companies — mainly those providing mutual funds. Investors can choose from various funds within a particular program, or they can sign up for plans administered by other states, not just their own.

In some programs, contribution minimums start at or below $50, yet investors usually can plunk down tens of thousands of dollars if they're willing and able. There are no income-eligibility restrictions, so affluent investors may open accounts.

Pain-free investing

Russ Ullinger, a tax auditor, set up a 529 plan a year ago for his grandson, now 3. "By the time he's 18, it will be nice," said Ullinger, a 50-year-old Peoria, Ariz., resident who uses Arizona's 529 program. He invests using a stock-market index fund, contributing automatically from each paycheck, which he said makes it convenient. "I don't see (the money) going out, miss it or even remember it," he quipped. "It's a great way to put stuff away."

The plans continue to grow in popularity, with $224 billion spread across 11 million accounts at the end of 2014, according to researcher Strategic Insight. Yet 529 programs still aren't familiar to a lot of people. Only 34% of respondents correctly identified them as a type of college-savings program in a survey released this month by Edward Jones.

The best 529 programs offer an ample selection of funds that perform well and feature low expenses. In its most recent 2014 analysis, researcher Morningstar singled out four 529 programs for its top "gold" designation — separate programs run by T. Rowe Price for Maryland and Alaska, along with the Vanguard/Upromise program for Nevada and the Utah Educational Savings Plan.

The existence of a 529 account might even be enough to get some kids excited about attending college.

"Children with any college savings are six times more likely to attend a four-year college than children with no dedicated college savings account," said April Osborn, executive director of the Arizona Commission for Postsecondary Education.

Russ Wiles can be reached at russ.wiles@arizonarepublic.com.