Save for College With a 529 College Savings Plan

Kids in schoolGetting tax advantages on the money you save for higher education is the big draw of section 529 plans. 529 plans, generally operated by the state you live in, come in the form of either a college savings plan or a prepaid tuition plan.

College savings plans

With a college savings plan, you contribute to an account that you can eventually tap to pay for qualified higher education expenses at any private or public school in any state. Nearly every state in the U.S. has its own college savings plan, and the various plans differ from state to state.

Contributions to a college savings plan are not deductible for federal income tax purposes, but some states may allow their residents to deduct contributions for state income tax purposes (please note, certain limitations do apply, be sure to contact your plan's administrator to determine what limits currently apply.) Withdrawals for qualified higher education expenses are exempt from federal, and in most cases, state income taxes. Qualified expenses include, among other things, tuition, fees and certain room and board charges. If money from a college savings plan account is used for nonqualified purposes, earnings on that money become subject to federal and state income tax in addition to an additional federal 10% tax. A state penalty may also apply (at the state level, a non-qualified distribution could be included in income as well as subject to a penalty).

A college savings plan offers multiple investment options for your account balance, and these options vary from plan to plan. As the account owner, you maintain control of the account, choosing among the investment options and deciding when to take withdrawals. There are no income restrictions tied to a college savings plan. There are also no annual contribution limits, but there are maximum account balances which vary by state, and are more than $200,000 per student. You can transfer an account to any eligible family member.

Prepaid tuition plans

Prepaid tuition plans are 529 plans offered by some states to allow you to guard against inflation by locking in current tuition rates. By contributing to a prepaid tuition plan (typically on an installment basis), you prepay tuition at any covered public college or university located in the state operating the plan.

Your contributions go into an account that gets credited with any investment earnings based on average tuition increases. You are not given any other investment options. Although your contributions are not deductible for federal income tax purposes, some states may allow residents to deduct contributions for state income tax purposes. Any earnings on your account that are used to pay qualified tuition are federal income tax free, and may be exempt from state and local taxes as well.

You can combine a prepaid tuition plan with other savings options. For example, you could potentially use the prepaid plan for tuition and a college savings plan for other qualified expenses, such as room and board.

Keep an eye on the federal gift tax

Contributions to a 529 plan being used to fund someone else's higher education are considered gifts. Under the annual gift tax exclusion, contributions of up to $14,000 per beneficiary for 2013 ($28,000 in the case of a married couple making the contributions) are exempt from federal gift tax. Speak with a qualified financial advisor before contributing an amount in excess of the annual gift tax exclusion.

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