So far in this series, the various alternatives for college savings have left something to be desired. Savings bonds are a fixed-income investment with no market risk, but no growth potential, either. Custodial accounts offer flexibility, but at the price of losing control of your money at an early age and unfavorable financial aid treatment. Coverdell ESAs give you both flexibility and control, but the limits for contributions are extremely low.
529 plans, also known as qualified state tuition programs, combine the positive elements of many of these alternatives into one package, while avoiding many of the negative aspects. Section 529 of the Internal Revenue Code gave states and educational institutions the right to set up such plans to benefit people who wanted to save for college. In response, all 50 states have established these plans.
The fact that there are 50 different plans to look at may sound overwhelming. Indeed, most states do not require that you be a resident of that particular state to participate in the state's 529 plan. On the other hand, some states offer state income tax incentives to residents who participate in their home state's plan.
General benefits of 529 plans
There are several positive elements of all 529 plans. First, the interest, dividends, and capital gains earned within a 529 plan are not subject to income tax each year. Instead, taxes are deferred. More importantly, under current law, as long as the money in the 529 plan is used for educational purposes, the income earned within the plan is entirely tax free. Unfortunately, the provision that makes withdrawals tax free is one of the many provisions that is set to expire at the end of 2010, so it is unclear whether this benefit will be available after that.
Second, you retain almost complete control of funds within the 529 plan. Although you designate a beneficiary to receive the funds, many 529 plans allow you to name yourself as the beneficiary; in any event, the beneficiary does not have any power to interfere with the plan while you own it. For financial aid purposes, the student is not considered the owner of 529 plan assets under current rules.
Third, there are no restrictions on who can participate in a 529 plan, and the contribution limits are much higher. No matter how much income you make, you can still open a 529 plan account. The maximum contributions allowed vary by state but for the most part range from $200,000 to $300,000 per child. Compared with the $2,000 limits on a Coverdell ESA, this is extremely attractive.
Last, while plans vary from state to state, a wide variety of different types of investments are available within 529 plans. You may not be able to invest in every individual stock you want, but mutual funds spanning all asset classes are available in some 529 plans.
Types of 529 plans
529 plans divide into two categories. Prepaid tuition plans give you the opportunity to pay now for future tuition. The amount you pay is based on current tuition costs. The idea is that no matter how much tuition costs rise between now and the time your child is ready to go to college, you have locked in the current price by depositing money into the plan. Despite the fact that many of these plans are state-specific and are based on costs of particular institutions, most plans allow you to use plan investments for out-of-state schools or schools not covered by the plan.
The second category is known as a savings plan. In these plans, you simply make a contribution and invest in one of a number of different investment choices. Like a 401(k) plan, the value of the 529 savings plan assets fluctuates over time, and when your child reaches college age, you are eligible to start taking withdrawals from the plan. There is no guarantee that your 529 plan investments will grow as quickly as tuition costs rise, but they may also grow faster than tuition costs, depending on the investments you choose.
Which 529 plan should you pick?
Unfortunately, both plans and state laws related to them vary so much that it's impossible to generalize about which plan is best. In general, however, a good 529 plan has a wide range of investment choices, low expenses, no sales commissions or other unnecessary fees, easy access to account information, strong customer service, and valuable state income tax incentives to residents.
Just because the state you live in has a 529 plan doesn't mean you should choose that plan. If your state doesn't offer any income tax benefits for choosing the state's plan, then you should pick whatever state's plan is best for you, regardless of whether you live there. Even if your state's plan does offer an income tax incentive to choose it, you still should weigh the tax advantage against any additional costs of using that plan. In some cases, even a tax incentive may not be enough to justify choosing your state's plan.
Hopefully, this series of articles has given you a good introduction to the world of education savings. If you want more information, consider visiting the Motley Fool's Paying for College discussion board. In addition, fellow Fool Robert Brokamp has some great information at the College Savings Center.
Lastly, remember that no matter how much you save for your child's education, your child will appreciate the help you provide -- perhaps not immediately, or a year from now, but at some point in the future. When put to good use, education is one of the best investments you can make in your child's life.
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Fool contributor Dan Caplinger welcomes your comments.