529 College Savings Plans: The Basics

How it works: A 529 plan is a tax-advantaged investment account that encourages saving for the future higher education of a beneficiary (typically the owner's child or grandchild). Named after section 529 of the Internal Revenue Service code, these plans are administered by state agencies. All withdrawals from 529 plans that are used for qualified education expenses are federally tax-free. Some states offer state tax-deferred growth and tax-free withdrawals for higher education expenses.

Who's eligible: Anyone can open a 529 account. And anyone can be named the beneficiary of the account, as long as the recipient is a U.S. citizen or resident alien and has a Social Security number or federal tax identification number.

Why? Investing in a 529 plan offers a tax-advantaged method of saving for a child's education. In addition to saving for college, 529 plans can be used as estate planning tools because a contribution to a 529 plan is considered a completed gift from the donor to the beneficiary named on the account, even though the account owner, not the beneficiary, maintains control over the money while it's in the account. Tax rules allow you to give $12,000 a year to as many individuals as you choose, and the money is free from federal gift taxes. So one method of reducing a taxable estate is to make scheduled gifts up to the tax-free limits each year.

Why not? Critics complain that 529 plans are too restrictive and that many of the funds, which are invested in equities and mutual funds, have taken a hit over the past few years like other funds invested in the market.

Playing catch-up: Even if your child is already in high school, it's not too late to open a 529. You can open an account for a beneficiary at any age and begin using the funds in the account, tax-free, as soon as they're needed.

2012 changes: Two changes that were included in the American Recovery and Reinvestment Act of 2009 were extended by the Tax Relief and Job Creation Act of 2010 and remain in effect for 2012. First, families saving for college can use 529 plans to pay for a student's computer-related technology needs. Second, more parents and students can use a federal education credit to pay part of the cost of college, using the new American opportunity credit.

The fine print: Many 529 plans incur fees from the states that oversee them and the investment firms that manage them. Make sure the administrative fees you'll incur won't cancel out the benefits of the plan.

Tools:
• College cost calculator http://www.collegesavings.org/collegeCostCalculator.aspx
• SavingForCollege.com: Is your institution 529-eligible?

Resources:
Best and worst performing 529 plans in 2010

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Saving for College vs. Saving for Retirement
Six Ways to Gift Money to Family