08/06/2014 12:50 pm ET Updated Oct 06, 2014

The Ins and Outs of 529 College Savings Plans

For many people, their biggest expenses in life are funding retirement, buying a home and paying for their children's college education -- or a portion of it, anyway. Setting aside money for these and other financial goals is difficult, especially when you're trying to save for them all simultaneously and from a young age.

Let's tackle saving for college. As with any long-term savings goal, the earlier you can start, the better. Two of the most popular savings vehicles are Coverdell Education Savings Accounts and 529 College Savings Plans. Both allow the earnings on your contributions to accumulate tax-free; and distributions used for qualified expenses also aren't taxed.

One advantage to Coverdell accounts is that they may be used for qualified elementary and secondary school expenses in addition to college. However, their contribution limits are much lower -- only $2,000 per year, per beneficiary. Also, you must stop contributing when your child turns 18, and the account must be liquidated when the child reaches age 30 or it will be subject to income tax as well as a 10 percent penalty tax.

There are two broad categories of 529 plans:
  • Prepaid tuition plans, which let you prepay college tuition at today's rates. Although your principal may be guaranteed by the state, you have no control over how your money is invested and you may be limited to public, in-state schools.
  • College savings plans, where you choose how your contributions are invested among the available risk-based options and can use the funds at any qualified public or private college, no matter which state.

Every state and Washington, D.C., offers at least one 529 plan option, although most offer several from which to choose. Because college savings plans are more popular, flexible and widely available, we'll concentrate on them. (To learn more about prepaid tuition plans, read this article.)

Key features of 529 college savings plans include:
  • You make contributions using after-tax dollars; their investment earnings grow tax-free.
  • Withdrawals aren't taxed if they're used to pay for qualified higher-education expenses (e.g., tuition, room and board, fees, books, supplies and equipment).
  • If you withdraw the money for non-qualified expenses, you'll have to pay income tax and a 10 percent penalty tax on the earnings portion of the withdrawal -- plus possible state penalties, depending on where you live.
  • Many states that have a state income tax give accountholders a full or partial tax deduction for contributions made to their own state's plan. Three states (Indiana, Utah and Vermont) also offer tax credits for contributions.
  • Contributions to other state's plans generally are not tax-deductible in your home state; however, five states do offer tax breaks for investing in any state's plan (Arizona, Kansas, Maine, Missouri and Pennsylvania). Note: Rules can change, so double-check plan documents before committing.
  • Each state's plan offers different investment options, both in terms of investment style (age-based, risk-based, guaranteed, principal protection, managed funds, indexed funds) and in the actual investment performance. About two-thirds of families invest in age-based asset allocation models, which gradually lower potential risk as college approaches.
  • You can choose anyone as beneficiary -- child, other relative or friend.
  • If the original beneficiary decides not to attend college or gets a scholarship, you can reallocate the account to another of his or her family members at any time.
  • You can rollover funds to a different 529 plan or change investment strategies once a year. If you want to do more than one rollover within a 12-month period, you'll need to change the beneficiary in order to avoid taxes and penalties. (You can always change it back later.)
  • Contributions up to $14,000 a year, per recipient, are exempt from gift taxes (up to $28,000 for married couples).
  • You can also make a lump-sum contribution of up to $70,000 ($140,000 if married) per beneficiary and then average the contribution over a five-year period without triggering the gift tax -- provided you make no other gifts to that beneficiary for the next five years.
  • These plans are treated as an asset of the account owner (vs. the student) when calculating the expected family contribution toward college costs, so they have a comparatively low impact on financial aid eligibility. (That's why it's important for parents or grandparents to maintain ownership of the account.)
  • There's no age limitation on when the recipient must use the funds, unlike Coverdell Accounts, where they must be spent by age 30.
  • Each state sets its own limit on maximum contributions and they vary considerably.
  • If you move to another state, find out if there's a penalty to roll over the money to a new account. If there is, it might make sense to leave the money in the existing plan and open an additional account in your new state.

Most financial experts recommend looking first at your own state's plan to see what tax advantages, if any, are offered to residents. They may be significant enough to offset lower fees or better fund performance in other states' plans.

Carefully examine the fee structure. Common fees include those for opening an account, annual maintenance, administration costs, and most importantly, sales commissions if you're buying from a brokerage -- which could be up to 5.75 percent of your contribution. Buying directly from the plan eliminates sales fees but puts the onus on you to research the best option for your needs.

And finally, examine the investment performance of the funds, both when you enroll and periodically thereafter. A number of independent analysts regularly review 529 plans state-by-state for performance and overall expense, including: Morningstar, College Savings Plans Network, and Warning: This can be a lengthy and complex process, which is why some people enlist a financial advisor's assistance.

Bottom line: College is getting more expensive every year. The sooner you can start saving, the less your kids will have to rely on expensive loans down the road.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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