529 plans: One of the best ways to save for college

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(MoneyWatch) It's no surprise that another consequence of the difficult economy is that parents continue to struggle to pay for their children's college costs. According to the most recent study by Sallie Mae, "How America Pays for College 2011," the amount parents paid towards college costs from savings and income has fallen from 36% to 30% over the past two years.

So what can you do about this? For starters, financial planning studies estimate that parents saving for college should save about 6% of their income annually to have sufficient assets accumulated by the time their child goes to college. Folks who are saving for their child's future college costs say they feel more confident in the fact that they have a plan to save. Some also report using supplemental funding sources and rewards programs (such as UPromise) to increase college savings. Clearly saving for college is a more viable strategy for parents with younger children who are years away from college than for those whose children are in their last few years of high school.

If you decide to do this, then strongly consider using a 529 education savings plan. These plans are state-sponsored savings and investment programs. The state sets up the plan with an asset management company of its choice, and you open a 529 plan account with that asset management company. Typically the parent is the owner of the account, and the child is the beneficiary.

The benefits of 529 plans

  • The account owner does not pay current income taxes on the unrealized gains in the account.
  • The owner/parent, not the child/beneficiary, always has control of the account.
  • If the beneficiary/child doesn't go to college, the account can be used for another family member or other individual.
  • Anyone can contribute to the account. There are no income limitations.
  • Most states have no age limit for when the money has to be used.

The big advantages of 529 plans are the tax benefits. First, while invested, the growth and investment gain on money in a 529 plan account is tax-deferred. Second, withdrawals are tax free as long as they are used for qualified higher education expenses of eligible education institutions. Generally this includes expenses for any accredited degree-granting educational institution, whether it is public, private, two-year, or four-year. Even some international schools qualify. In most states, qualified education costs include tuition, fees, books, supplies, room, board, transportation, and even computers when one is required by the school. Lastly, about 35 states offer tax benefits such as an above-the-line deduction from income or a tax credit for all or a portion of the contributions of their residents who contribute to their own state sponsored 529 saving plan.

Folks concerned that these benefits are too good to last should take comfort in the fact that in 2006 Congress approved a 529 tax permanency provision, removing the uncertainty surrounding the tax treatment of 529 plans and provides college savers using 529 plans with unique tax benefits going forward.

If the money in the account is no longer needed for college (because the child gets a scholarship, doesn't go to college, etc) then the account owner can withdraw the unused money. When withdrawals are taken for non-qualified distributions, the earnings are taxed at ordinary income tax rates and there is also a 10% penalty on the investment earnings. The taxes and penalty are not assessed on principal. Distributions are allocated between principal and earnings on a pro-rata basis. An exception to the penalty can be claimed if you terminate the account because the beneficiary has died or is disabled, or if you withdraw funds not needed for college because the beneficiary has received a scholarship.

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.

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