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The ABCs of College Savings Plans

State-run 529 plans are a great way to save for college.

With the average annual college tuition bill topping $4,000 at public, four-year colleges and universities, and as high as $19,500 at private, four-year schools, you may be wondering if you'll ever afford to send your kids. There are many ways you can gradually sock away cash for future college costs -- including Coverdell Education Savings Accounts (formerly known as Education IRAs), zero-coupon bonds, and custodial accounts. But figuring out which method is best can be as complicated as advanced calculus.

However, one type of savings tool -- state-sponsored college savings plans -- is a real standout. Though they've been criticized in the past for being too restrictive and wreaking havoc on students' financial aid prospects, they deserve a second look now that provisions in the recent tax law have improved them.

How They Work

You may have heard of 529 Plans, an umbrella term used to describe both college savings plans and prepaid tuition programs. (Most states offer one or both types of plans.) Prepaid plans let parents lock in today's prices for tuition, room, and board by paying these college expenses up front, either in a lump sum or in installments. On the other hand, savings plans let you make monthly or quarterly contributions (as little as $15 or $20 per pay period through automatic payment programs in some states) to an account which the state invests on your behalf. Many states have top mutual fund companies (including Fidelity, T. Rowe Price, and TIAA-CREF) steering the investments, which are spread over a mix of stocks, bonds, and cash equivalents, depending on the age of the child.

Both types of plans generally let anyone (a parent, grandparent, relative, or friend) set up an account and make contributions, regardless of income. And most states set high ceilings on the amount you can put in -- as much as $200,000 or so in some states.

While prepaid plans are guaranteed to keep up with college cost increases -- which hit 5.7 percent at four-year public colleges in the 2003-2004 school year and 9.8 percent at private four-year schools, according to The College Board -- college savings plans are especially attractive because of their unlimited potential growth, particularly if you enroll when the child is very young. Furthermore, while money in either type of plan can typically be used to pay for expenses at any accredited college or university in the country, you may not be allowed to apply the full balance from a prepaid tuition account to an out-of-state school, depending on the state's rules.

Starting in 2004, private colleges and universities can establish similar prepayment or savings plans, and the distributions from the plans will be tax-free.

The Advantages

Besides offering parents hands-off college investing, 529 plans allow you to build up college savings tax-free. Furthermore, under the new tax law, any withdrawals from 529 plans after 2002 are tax-free if used to pay for a beneficiary's college tuition, fees, books, supplies, and -- for students enrolled at least half time -- room and board. (Previously, withdrawals were taxed at the beneficiary's tax rate.)

What's more, some states pile on additional tax breaks for resident enrollees. For example, New York's College Savings Program lets participating New Yorkers deduct up to $5,000 ($10,000 for married taxpayers filing joint returns) from their state taxes. Kansas taxpayers who enroll in the state's Learning Quest Education Savings Program can deduct up to $2,000 per student yearly ($4,000 per student for married joint filers) on state returns.

The new tax law also allows you to roll over funds from one state's 529 plan to another state's plan once every 12 months, if you move or if you're unhappy with your current plan. You can transfer funds to another 529 plan at any time if you change the beneficiary as well.

Finally, unlike custodial accounts that come under the beneficiary's control on his 18th or 21st birthday (depending on the state), the funds in a 529 plan remain under parent's or grandparent's control.

The Disadvantages

Despite their strengths, 529 plans do have drawbacks. For starters, the money in the account may only be used to pay for higher education expenses. If the money is used for any other purpose, the earnings are taxed and subject to a 10% percent penalty. (There is no penalty if the account can't be used for education expenses because the beneficiary is disabled, or gets a tax-free scholarship.)

So what happens if your kid decides to go off and "find himself" instead of attending college? The account owner (normally the parent or grandparent) can name another family member as beneficiary, such as a sibling or even a first cousin. Otherwise, the money in the account is refunded to the donor and taxed.

Another caveat: If you're relying on financial aid to foot some of the college bills, tread carefully. The assets you accumulate in a 529 account might be factored into the school's financial aid equation -- possibly reducing any aid your child might otherwise receive.

You should also know that the federal tax law provisions allowing for tax-free withdrawals are set to expire in the year 2010. It's unlikely Uncle Sam would snatch tax perks from families with existing accounts however, so if you're considering enrolling in a state savings plan, don't put it off too long.

Choosing a Plan

Most states' plans are open to residents and nonresidents, though nonresidents can't take advantage of the state tax breaks. You'll have to do your homework, though since the plans vary widely from state to state. For example, some states require that the funds be held in the account for a minimum period of time, before withdrawals can be taken. Other states require that the funds be used within 10 years of the beneficiary's high school graduation.

To compare various state plans, check out "The 529 Evaluator" at the Saving for College Web site. Be sure you understand how your contributions would be invested, what types of fees and penalties might apply, and other plan limitations.

Check Out the 529 Evaluator

Tax Perks for Parents

A Road Map for Financing Your Child's Education

Understanding the Financial Aid Process

Quiz: Are You in Control of Your Money?

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