NEW YORK (MONEY magazine) -
For parents struggling to save for their children's college bills, tax breaks have been few and frustrating.
Custodial accounts? The tax savings are minimal, and you give up control of the assets to your kid. State-run prepaid tuition plans? They lock you into sub-par returns.
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The 529 Solution
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The Coverdell Education Savings Account (formerly known as the Education IRA) is a decent option, since all savings grow tax-deferred and withdrawals are tax-free. But you can put away only $2,000 a year, hardly enough to cover the rising cost of college.
Little wonder that most parents end up saving in taxable accounts -- thereby sacrificing a big piece of their profits to Uncle Sam -- or raiding their retirement accounts.
Enter the 529. These state college savings plans, named after the section of the tax code that governs them, are the more attractive siblings of prepaid tuition programs.
A state's prepaid plan allows you to pay now -- at today's tuition rates -- for school tomorrow. But 529s, now offered in most states, are far more flexible.
Benefits of a 529
The money may be used at any school you choose and for all qualified higher education expenses, including room and board (not so with a pre-paid plan).
Most 529 savings plans offer a menu of age-based portfolios, and some also offer a small selection of stock and bond funds. In the former case, your annual contributions get invested in a pre-selected portfolio of stocks and bonds.
Early on, the portfolio is tilted toward stocks, and as the time for college nears, the weighting shifts more heavily toward bonds. States contract out to investments companies, such as TIAA-CREF and Fidelity, to manage the portfolios.
You never have to worry about annual taxes on dividends and gains, and withdrawals are tax-free too (at least until 2010, when Congress has the option of extending the break). What's more, if you invest with your own state's 529, you may get state-tax deductions on contributions or exemptions on withdrawals (you may, however, choose to forego the state tax break if another state has a better 529).
Contribution limits are generous
Investment minimums are low (plans may let you sock away as little as $25 a month), and there is no restriction on how much you may contribute every year unless the account is nearing the lifetime cap.
Each state determines its own lifetime contribution limit, ranging between $100,000 and $270,000.
Just because you can contribute as much as you want, however, doesn't mean you should -- annual contributions of more than $11,000 ($22,000 if contributing with a spouse) are subject to the gift tax.
One caveat to the gift-tax limit: You may contribute as much as $55,000 tax-free in one year ($110,000 with your spouse), but that contribution will be treated as if it were being made in $11,000 installments over the next five years. In other words, you can't make such a large contribution every year without tax consequences.
Next: Who should get one
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