Everything You Need to Know About 529 Plans

Whether your child is 7 months old or nearly 17, you've probably woken up in a cold sweat over the nightmare of college tuition bills. So far, no one has figured out a way to make those ever-rising expenses disappear, but the Internal Revenue Service has made saving a little bit easier, with the 529 College Savings Plan. To put it simply, these plans allow you to put aside pretax dollars for higher education expenses like tuition and books. The money also isn't subject to federal taxes. Plus, 30 states give tax breaks for saving in a 529. We walk you through the benefits of 529 plans, how to fund them, and how to choose the best one for your family's needs.

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What is a 529 Plan?

The 529 plan, named for the tax code that created it, is chock-full of tax breaks and other advantages. Money saved in 529 plans can be used for tuition, room, and board at any accredited educational facility—including undergraduate and graduate school, community colleges and even some trade schools. If you're saving for college (or graduate school, for that matter) you may want to start a 529 of your own. Here's why:

529 plans encompass the best parts of other college savings vehicles. It's very much like a Roth IRA, in that you can invest after-tax dollars. The money grows tax-free and the withdrawals are tax-free. And the contribution limits of 529 plans are much higher than Roths, which have a $2,000-a-year limit. 529 plan contributions can be more than $200,000 per child, depending on the state plan you choose. Unlike other college savings plans, you don't have to stick to the original beneficiary (you can move the account from child to child, or even to other relatives, if needed, by simply changing the beneficiary). You only need one account to satisfy your entire family's needs.

Related: The 10 Best Colleges in the U.S. Cost Less Than $25,000 Per Year

What Are the Benefits of a 529 Plan?

Tax breaks are one of the biggest benefits of 529 plans. The money you invest grows tax-deferred, and as long as you withdraw the funds for educational purposes, the earnings that accrue are tax-free. Depending on which state's plan you choose, you may also qualify for state tax breaks.

Don't confuse the 529 savings program with pre-paid tuition plans. Pre-paid tuition plans allow you to pay today's prices for credits at in-state universities, and they do allow you to transfer the value of your contract to cover tuition and expenses at out-of-state schools (though you may lose some value upon transfer, depending on the plan). In contrast, when you open a 529 plan, you're not buying credits at a specific college in a specific state, but you're saving for college expenses regardless of where your child chooses to go. You can use the funds from 529 plans at any accredited school in the country, regardless of state.

Another advantage is the flexibility you have with assigning a beneficiary to the account. Say you have two kids, and you open a 529 account for your oldest. But at age 18, she decides to skip college in favor of another endeavor. If the college savings were in a Coverdell Savings Account (also known as an Education IRA), for example, you'd face a 10 percent penalty for withdrawing the money for non-education expenses —and you'd owe taxes on the earnings. But with a 529 plan, you can simply change the beneficiary of the plan to your younger child or another relative, without facing any penalty or taxes.

"If you have several kids, what's the chance in this day and age of one of them not going to college?" says Altair Gobo, a certified financial planner with U.S. Financial Services in Fairfield, N.J. "You can simply change the beneficiary to someone who is going to go to school."

That means you only need one 529 account for all the future college-goers in your family. Start with your oldest child as the beneficiary, and pay her college bills from the account. When your younger child is ready to go to college, just change the beneficiary.

Related: How to Teach Kids Financial Responsibility at Any Age

And if your kids never go to college and you don't have another relative you'd like to make the beneficiary of the account, or on the off-chance you save too much in a 529 plan, you can simply withdraw the money, paying taxes on earnings and a 10 percent penalty.

Many parents favor 529s over other accounts because you—and not your child—stay in control of the account. For example, with Uniform Gift To Minor Accounts (UGMAs), the beneficiary (your child) is the owner of the account. That means when the child reaches the age of majority (18 or 21, depending on the state), he could buy a new Corvette instead of paying tuition bills. You'd have no legal say in the matter. But because you keep control of the 529, you can decide how and when the funds are distributed.

And 529s have such a high contribution limit—over $200,000 per child in many states—that they make the savings in other plans, such as the Coverdell (which has a $2,000-per-year limit) seem paltry by comparison. Because the contribution levels vary by state, take a look at savingforcollege.com, which offers a rundown on every state plan, including contribution limits.

How to Contribute to a 529 Plan

529s are very popular with grandparents who wish to gift money to their heirs as part of an estate plan. "There are some huge estate tax advantages to 529s for grandparents who have been advised to start transferring money to the next generation," says Daniel Galli, a certified financial planner with Boston 128 Companies of Rockland, Mass.

You can now bunch together five years' worth of gifts—something you previously couldn't do without triggering a taxable event. Galli offers this scenario: Imagine a grandparent is trying to reduce his estate for tax purposes, and he plans to gift money to his grandchild. Under normal circumstances, the grandparent could give $11,000 in 2002 without triggering a taxable event. But if the money goes to a 529 plan, the grandparent can give $55,000, or five years' worth of gifts, in one shot. Not only will the beneficiary have that larger chunk of money earning interest tax-free, the grandparent will reduce the money in his estate faster than by giving gifts annually.

How to Choose the Best 529 Plan

When choosing a plan, look first to the program offered by the state in which you live, but don't automatically sign up, says Galli. Some states offer 529s, others have pre-paid tuition plans, some offer both.

"The first thing that's critical is to see if your state offers any kind of state tax break for using their plan. That's the one issue that gives your state a leg up on any other state plan," Galli says. But not all states do. In his home state of Massachusetts, residents don't get any additional tax breaks, so Massachusetts investors would do just as well tax-wise with an out-of-state plan.

Related: 5 Brilliant Tips to Make Filing for Taxes Easier and Less Stressful

You should next take a look at which investment companies administer the plans you're considering. If, for example, you prefer Vanguard or Fidelity, you may want a plan with investment choices from those fund families.

Most plans offer investment choices based on your time horizon, called age-based portfolios. For example, the plan will invest aggressively for a 3-year-old child, and then as the child nears age 18, assets will be moved towards more conservative investments. Or, if you'd rather be more or less aggressive over the course of the plan, many states offer other asset allocations.

As with any investment, take a close look at the plan's expenses. There's a big difference in the bottom line of earnings between an account with an expense ratio of .25 percent or 2 percent, and some states even charge an annual fee. To compare plans' fees and find comprehensive information about 529s, check out www.savingforcollege.com.

Contributing is easy. You can elect to make one-time contributions, automatic contributions to a 529 from a bank account, and some employers even offer payroll deductions to participate in a plan.

Other Considerations

Before you sock away all of your college savings in a 529, consider how the funds will impact your child's chance of receiving financial aid.

"There is some uncertainty in financial aid treatment when you take money out of your 529 account and how it will be counted when computing eligibility for financial aid," says Joseph Hurley, a certified public accountant and founder of savingforcollege.com.

Hurley says some programs will let the recipient decide who gets the withdrawals: the account owner or the beneficiary. That will determine who has to report the income on their tax return. If it's reported by the beneficiary, your child could lose out on financial aid. Financial aid officers consider 35 percent of a child's assets to be earmarked for college, so income from a 529 plan will probably hurt her chances for aid. At the same time, only 6 percent of a parent's assets are considered earmarked for college, so funds owned by the parent won't count as much.

That doesn't mean you shouldn't invest in a 529. Many families in higher income brackets aren't planning on getting much aid anyway, so the tax advantages of a 529 could be a no-brainer. But if you think your family will need a substantial amount of aid, planners say parents may be better off saving funds in other accounts in their own names instead of the child's. In other words, you shouldn't necessarily use a 529 but instead should invest in regular mutual funds in the parents' names, earmarking the funds to pay for college.

If you're a few short years away from the tuition bills, a 529's tax breaks and other advantages may not be worth it.

"Unless you have at least three years to go, there's probably not a lot of advantage in the 529," says Galli. "Some state plans have penalties for taking money out too quickly."