Saving for College with a 529 Plan Keeps Getting More Attractive If you're saving for college or graduate school and have not yet invested in a state-sponsored 529 plan, both federal and state governments are giving you more reasons to do so. At the state level, several have cut the fees associated with these popular college funding tools as an incentive to invest in their state's plan. The federal government is helping out as well. On February 8, 2006, Congress signed into law the Deficit Reduction Act of 2005 giving long-awaited clarity to the financial aid treatment of 529 plans. A 529 plan offers several benefits, including significant tax advantages. There are two types of 529 plans-prepaid and savings-and both allow families to invest after-tax dollars into an account that grows tax-deferred. A 529 prepaid plan allows you to lock in the cost of future tuition by purchasing it at a price set today, essentially making the performance based on tuition inflation. A 529 savings plan allows you to make deposits into an account where you select the investment choices.

Smaller impact on financial aid
Currently, assets in a 529 prepaid plan reduce a student's financial aid award dollar-for-dollar. For a 529 savings plan, the Department of Education guideline suggests using 5.6 % of parent-owned plan assets in determining a student's financial aid award and 35% of plan assets if owned by the student.

However, beginning July 1, 2006, the maximum percentage of assets in any parent-owned 529 plan (savings or prepaid) a family will be expected to contribute each year toward college expenses is 5.6%. For all student-owned plans, the rate will remain at 35%. This new law makes clear the impact a 529 plan has on financial aid and eliminates a significant disadvantage of a prepaid plan.

What makes 529 plans worth a look?
One of the primary benefits of a 529 plan is the tax treatment. Distributions are federally tax-free as long as they are used to pay for qualified higher-education expenses at an accredited college or university in the U.S. and even some foreign institutions. For a 529 savings plan qualified higher-education expenses can include a variety of expenses including tuition, room, board, books, etc. For a 529 prepaid plan, distributions are tax-free if used to pay for tuition.

Although you can invest in any state's 529 plan (every state offers at least one), many states also offer state income tax deductions on contributions as well as other potential benefits as an incentive to invest in their own 529 plan.

Even more reason
There are three other important advantages of using a 529 plan to save for the cost of a college education: control, simplicity and availability.

Control. As the donor/owner, you have sole control of the account so you specify the amount and timing of all distributions. You can also change the beneficiary of the account to another qualifying family member at any time and keep the benefits of tax-deferred earnings growth.

If you want the money for something other than college costs, you can even make "non-qualified" distributions from the account. Although these distributions are subject to income tax and a 10% penalty on any earnings, several exceptions to this penalty exist. Terminating the account due to the death or disability of the beneficiary, or withdrawing the funds because the beneficiary received a scholarship and does not need the money for college education expenses are two exceptions.

Simplicity. The most difficult aspect about 529 plans is selecting one. Once you select a plan, you can make a one-time investment, sign-up for automatic deposits or make future deposits whenever it's convenient. The state treasurer's office or a professional investment management company (selected by the state) manages the plan assets and provides investment choices based on age and/or risk tolerance. In many plans, the asset allocation is automatically adjusted to reduce the investment volatility as your child nears college age. This usually means going to a more conservative investment strategy.

Availability. Because there are generally no income limitations or age restrictions, everyone is eligible to take advantage of a 529 plan. You can even open a 529 plan for yourself. And, the maximum amount you can invest into a 529 plan is considerable-$230,000 or more, per beneficiary in many state plans.1

Another consideration
One thing to keep in mind is the potential that the current tax exclusions of 529 plans were part of the Economic Growth Tax Relief Reconciliation Act (EGTRRA) of 2001. Although EGTRRA is currently scheduled to "sunset" on December 31, 2010 when the tax laws are to revert back to the 2001 levels, indications point to Congress extending these provisions.

In February, the Bush administration unveiled its Fiscal Year 2007 Budget containing a proposal that would make permanent the federal tax exclusion for qualified withdrawals from 529 plans, along with other tax changes in the EGTRRA and the Job and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA).