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Saving for College- Section 529 Plans can Help

According to the College Board, four years of tuition, room, and board runs about $90,000 for a private college and $34,000 for a public institution. Eighteen years from now, those figures are projected to rise to $235,000 and $100,000, respectively.

Don’t panic. You can use a 529 plan to channel a significant chunk of money into a child’s college savings account, while receiving the benefit of professional investment management with the child’s college dates in mind. And earnings and withdrawals will be tax-free as long as the money is used to pay qualified higher education expenses—including room, board, books, and fees.

The mechanics of 529 plans differ slightly from state to state, but in general here’s how to get started on the road to college savings.

  • Choose a plan. Begin with your own state’s plan because you could qualify for a grant, scholarship, tax deduction for your contributions, or tax break on withdrawals. If it doesn’t offer enough benefits to make its plan an automatic choice, look around. Many states allow nonresidents to open accounts. The plan should offer solid investment choices and be managed by a nationally recognized investment company. Plans often times will allow either investment in their portfolios or direct investment into the mutual funds they use in the portfolios. Costs are also a consideration. Most states charge an account fee, but expense ratios and other fees can add up. Be sure to ask about them.
  • Open an account. Most plans allow contributions as low as $25 a month. Maximum contribution limits vary from state to state, ranging between $100,000 and $300,000. You can have more than one account in a child’s name, but your total lifetime contributions to all of the accounts cannot exceed the state maximum.
  • Select an investment option. Most 529 plans are built around age-based portfolios. They weight investments more aggressively for children in their early years and become more conservative as the college deadline approaches. You can even roll over from one plan to another if you have a change of heart about your investment choice. Rollovers are limited to one per year.
  • Contribute regularly and encourage others to add to your child’s savings. You can deposit up to $55,000 in one lump sum ($110,000 for a couple) to any child’s account without triggering a federal gift tax. A maximum contribution counts against an individual’s $10,000 annual gift exclusion for five years, so you can’t make another tax-free gift to that child for six years.

When your child enters college, you can begin withdrawing money to pay for tuition at any accredited degree-granting school. If your child opts not to go to college, or if there is money left over after expenses are paid, you could name a new family member as beneficiary. Because the money is yours—not your child’s—you’re free to withdraw the balance and pay tax on the earnings at your income tax rate, plus a 10-percent penalty.
*The fees, expenses and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee a college-funding goal will be met. Under current federal tax law, the tax-free treatment of qualified 529 plan distributions ends December 31, 2010.

Earnings must be used to pay for qualified higher education expenses to be federally tax-free. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and will be subject to a 10-percent penalty.