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Why 529 Plans Are the Answer for College Savings

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With college costs soaring, students face a seemingly insurmountable challenge: how to come up with the money to attend college without digging themselves into a huge hole of debt that will dominate their financial lives for years after they graduate.

But parents and grandparents are answering the call, according to the College Savings Plans Network. By using tax-favored savings vehicles known as 529 plans, family members are taking advantage of the chance to set money aside for their children's or grandchildren's education while reaping some rewards from the IRS in the bargain.

Why 529s are on the rise
The College Savings Plan Network's recent report said that use of 529 college savings and prepaid tuition plans hit a new record in 2012, with the average account balance rising 12% to $17,174. The number of accounts rose more modestly, with 11.1 million accounts as of the end of 2012 versus 10.7 million in the previous year.

The healthy returns in the stock and bond markets also played a big role in boosting overall college savings. The total amount invested in 529 plans also hit a record, topping the $190 billion mark, up more than $25 billion from 2011.

Why should you use a 529?
529 plan accounts for college savings work a lot like IRAs and 401(k) plan accounts for retirement savings. In a 529, you don't have to worry about paying taxes on the income and gains that your investments generate. As long as the money stays within the plan, it's tax-deferred. Moreover, if you eventually use the money in the 529 plan for qualified educational expenses, any income on your investments becomes tax-free, amounting to a big subsidy from the IRS toward a college education.

The tax savings in a 529 plan can add up to a lot. If you save $10,000 and invest it in a normal taxable account generating returns of 5%, then you'll earn $500 in income every year. Someone in the 25% tax bracket will have to pay $125 in taxes annually on that income, adding up to $2,000 or more over the course of 16 years or so of saving for college. In a 529, that's extra money that you can use toward college expenses.

How to do better
The problem, though, is that just over $17,000 toward college expenses doesn't go very far. The average room and board for a single year at a public college or university is slightly above that figure, and for private schools, $17,000 won't even pay for half a year of expenses.

Obviously, the best answer is to save more in your 529 plan. But if you've already saved as much as you can afford, consider these tips to boost the investing power of what you have:

  • Find the top plans. Contrary to what you might think, you don't have to go with the 529 plan that your own state offers. Instead, you can pick from among the best 529 plans around the country. The experts at Savingforcollege.com and Morningstar have picked plans from Nevada, Utah, New York, and Alaska as some of the best and most inexpensive plans around. T. Rowe Price (NASDAQ: TROW  ) runs the Alaska plan with its low-cost, highly rated investment options, while Vanguard has a hand in the New York, Nevada, and Utah plans. With investments like the institutional-fund equivalent of Vanguard Total Stock Market ETF (NYSEMKT: VTI  ) , you can get the growth potential of owning stocks at rock-bottom fees.
  • Don't overpay. By contrast, some companies that provide investment options for 529 plans charge extremely high fees. Several low-rated plans are managed by AllianceBernstein's (NYSE: AB  ) fund-investment group, with investment options that have had lackluster performance with relatively high costs. In 2012, Morningstar pointed out Schwab's (NYSE: SCHW  ) Kansas 529 plan as having the highest fees of any direct-sold plan, arguing that "the expense ratios on the [investment] options are so high that they make it very unlikely that the plan will outperform over the long term."
  • Look for extra breaks. Some states offer special benefits for residents who pick their plans, including breaks on state income taxes. Those perks can be a good tiebreaker in considering the best plan for you, although they shouldn't drive your decision entirely. Sometimes, even plans offering local tax savings have high costs that outweigh the benefits.

Take a closer look
529 plans can be a great answer for parents and grandparents looking to help students out with their college expenses. To get even more useful information, click here to learn more about 529 plans and various other college savings options at your disposal.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 25, 2013, at 10:00 AM, puccini3005 wrote:

    ... and don't forget ESA's (Educational Savings Accounts) which offer the same benefits, and in some cases, greater flexibility...

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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