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by Randall F. Rothstein, CPA, PFS, CCPS
Certified Public Accountant
Accredited Personal Financial Specialist
Certified College Planning Specialist

For most families the biggest expenses are also the most worthwhile: a nice home, a comfortable retirement and a good college education for the children. Of course, the cost of all of these "luxuries" is rising all the time. Few families can come up with the money, all at once, to pay for the better things in life. The usual solution is to save. You save for a down payment on a home, you sock money away in a retirement plan for your golden years and, if you're smart, you put money away on a regular basis for your children's education. And, it's never too early to start saving for the high--and rising--costs of a college education.

Well, I have some good news for you if you're interested in saving, in advance, for your children's college costs: You have several options from which to choose, and one or more of the available savings programs is sure to meet your needs.
One of those college savings programs is called the 529 Plan. It gets its name from the law that created it, Section 529 of the U.S. Internal Revenue Code. Officially, 529 plans are known as Qualified State Tuition Programs, or QSTPs, for short. But most people refer to them as 529 plans for simplicity's sake.

529 plans are a tax-advantaged way for families at any
income level to save for college.

By "tax-advantaged," I mean that these investment plans offer distinct tax advantages that may prove very beneficial for you and your family. In a moment, I'll discuss in more detail about those tax advantages and other benefits of 529 plans. But first, you need to know…

529 plans come in two distinct "flavors":
prepaid tuition plans and savings plans.

With a 529 prepaid tuition plan, you purchase either tuition credits or units from the state. There are some significant differences between credits and units, but space doesn't permit a complete explanation here.

Simply speaking, though, you pay for tuition credits or units today at today's prices. This protects you against the sting of inflation. You can pay all at once or at intervals over an extended time.

A 529 prepaid tuition plan is professionally managed by the state's treasurer's office or by an investment management company hired by the state. The collective money of all participants is invested by the managers. The investment goal is to keep up with inflation so that the plan can meet its future obligations to participants.

The second type of 529 plan, which is known as a savings plan, is also professionally managed. The managers invest participants' contributions in mutual funds and other investments, with the goal of increasing the value of the contributions.

You will need or want professional assistance to help determine
which type of 529 plan is best for your family.

That's because the two types of plans have some significant differences, and in many cases you do have a choice of plans. Now that we've covered the two types of 529 plans, let's take a look at the pros and cons of 529 plans in general. Here are the main advantages:

Just a few months ago, a law was passed making 529 plans fully exempt from federal taxes, effective in 2002. As long as you withdraw the money for qualified higher education expenses, you do not have to pay any federal taxes on the earnings. "Qualified higher education expenses" include tuition, books, equipment, supplies, and at least some portion of room and board.

Contributions you make into a 529 plan are considered to be "completed gifts" to the beneficiary (student)--even if the beneficiary will not actually use the money for several years. This has important estate planning advantages as well as current tax advantages.

You can put a lot of money into the plan--in some cases, up to $100,000 in one year--without being required to pay a gift tax. This makes 529 plans especially attractive to high-income families. But you don't have to make big bucks to enjoy the benefits of a 529; it's for families from all income levels.

Most of the plans are not just for undergraduate students. They can also be set up for graduate, law or medical school. And usually there is no age limit for the student.

You control when money is distributed from the plan.

You can change the name of the beneficiary (student) as long as he or she is still a member of your family.

If another state's plan is more attractive than the plan available in your own state, you may be able to sign up for the out-of-state plan.

In most cases, your youngster can go to school in a different state than the one in which you set up the plan. This is important because you can't really know, years in advance, where your daughter or son will eventually want to pursue a higher education.

If you need the money in your 529 account for something other than qualified higher education expenses, you can make a withdrawal. However, you will be charged a penalty for that privilege.

In general, your 529 plan should not have too much of a negative effect on your child's chances for getting other forms of financial aid. I say "in general" because this gets quite complicated depending on the type of plan and many other factors. I can help you sort out the facts and determine what impact, if any, a 529 plan will have on financial aid eligibility in your family's case.

For estate planning purposes, the money in a 529 plan is considered out of your estate. So, a 529 could be a good strategy if you or a grandparent are looking for ways to reduce your estate-tax exposure while also helping to reduce the cost of your child's college education.

Keep in mind that every family's situation is different, of course, so some of these benefits may not apply to you.

Just as there are advantages of 529 plans, there are also some disadvantages, including these:

Because the plans are professionally managed, you don't have much control over how the money is invested. (If you don't like how the account is managed, you could decide to roll it over to another state, as long as that state doesn't have any residency restrictions.)

The plans are not necessarily exempt from state income taxes.

As mentioned above, you will be charged a penalty if you withdraw money from your 529 account for anything other than qualified higher education expenses. The typical penalty is 10 percent on earnings (not principal) and is charged by the state. However, starting in 2002, the federal government will charge its own 10 percent penalty. It's expected that the states will respond by removing their penalties, so you'll get hit only once.

Except in a few cases, such as the death of the beneficiary, if you make a withdrawal for anything other than qualified higher education expenses, you also will have to pay taxes on the earnings portion of the withdrawal. And, since your 529 account is considered a parental--not student--asset, it will be taxed at your rate, which is probably considerably higher than your child's tax rate.

Depending on the plan's specific requirements, you may need to provide some kind of proof that withdrawals have been used for qualified higher education expenses. Some plans require that money be paid directly by the plan administrators to the school; this takes control out of your hands.

So, there you have it ... an overview of 529 plans--an increasingly popular and advantageous way to save for college on a "tax favored" basis.

Please do not run out and buy this type of investment (or any other investment) until you or a professional, with full knowledge of the 529 Plans, has complete understanding of the investment product, your family's situation and how this investment will effect your eligibility for financial aid.

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