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The 529 Plan: College Savings

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By Robert Brokamp

A 529 college savings plan is pretty much an investment account. Unlike a 529 prepaid tuition plan, a 529 college savings plan does not lock in future college tuition costs at today's prices. Instead, it affords an opportunity for investments to grow through the years at rates that equal -- or better yet, exceed -- future increases in college tuition costs.

Investments in a 529 savings plan grow tax-free as long as the money is used to pay for qualified higher-education expenses (tuition, fees, books, supplies, and room and board). While contributions to the 529 are not federally tax-deductible, some states permit a partial or complete state tax deduction to residents.

Anyone may contribute to a 529 plan. You don't even necessarily have to live in the state of the plan that you choose. You could live in New Mexico and contribute to a plan based in Maine for your grandchild who lives in Oregon and who ends up going to college in Michigan. If you're thinking of going back to school, most plans will even allow you to set up a 529 savings account for yourself.

The contribution limits to 529 plans are very high -- more than $200,000 in most cases. Most of these plans have no age or income limitations, so higher-bracket taxpayers can participate. Unlike a custodial account (e.g., Coverdell, UGMA, UTMA), the assets in a 529 college savings plan remain in your control. With only a few exceptions, your kids can't grab the money and run off to Europe when they reach the age of majority. You decide when distributions are made, and what the funds will be used for. (At last, something you can lord over the kids after they turn 18!)

If you remove the earnings from the 529 plan and decide not to use them for higher-education expenses, you'll not only pay taxes on those earnings, but you'll get zapped with a 10% penalty. However, most 529 plans will allow you to change beneficiaries. So, if your child decides not to attend college, you can transfer the 529 plan account to a new beneficiary who is directly related to your kid (including cousins, step-relatives, and in-laws).

Perhaps the biggest knock on 529 college savings plans is their inflexibility. You can't directly manage the funds yourself; you must choose a money manager (think mutual fund). The number of investment options varies from plan to plan, ranging from only a few funds to almost 30. Also, once you've chosen your asset allocation, you can't change the mix for 12 months. If you're not happy with the 529 plan itself, you can transfer to another plan -- but just once every 12 months.

See the College Savings Plan Comparison Chart for the whole kit and caboodle.

How to choose a 529 savings plan

Just about every state offers a 529 plan. The quality of the plans, and their rules and regulations, vary dramatically. We can't emphasize enough how much these plans differ from one another. For example, most plans allow the account owner to change beneficiaries -- but some don't. So, spend time getting to know what's out there. Unfortunately, since most of the plans are just a few years old, they don't have an extensive history to evaluate. Also, since the 529 market is rapidly growing, expect significant changes in the coming years.

The best place to compare 529 plans is at savingforcollege.com, which offers a 529 plan evaluator and a rating for each plan. If you want a snapshot of all the plans, check out BusinessWeek's Guide to College-Savings Plans.

Generally, here's what to look for:

  • Low expenses: Watch for enrollment fees, transfer fees, annual fees, and the annual expenses on the investments. Generally, we recommend that you don't consider plans with investments that charge more than 1.5% a year -- and you can find investments that charge much less. Also, depending on the plan, you may have to pay an upfront commission.
  • A variety of good investments: Some plans offer just a couple of ho-hum choices, whereas others offer a menu of more than 20 mutual funds. You want flexibility and respectable performance.
  • Perks for residents: Since some states offer incentives for residents to choose their plan, you may not need to look farther than your own backyard. Such incentives include state tax deductions, scholarships, and matching contributions.
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