The best way to save for college

Some say there are good reasons to bypass a 529 account. Don't believe them.

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By Walecia Konrad, Money Magazine contributing writer

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(Money Magazine) -- Since their introduction in 1996, the now ubiquitous state-sponsored 529 college savings plans have been lauded again and again as one of the best tax breaks since the IRA.

Named after the section of the tax code that governs them, 529s let you save large sums while your earnings accumulate tax-free; the earnings remain tax-free as long as you use the money to pay for college.

Great as these plans are, however, some 70% of parents saving for college don't use them, according to the College Savings Foundation. Instead, they invest in stocks, bonds, funds or even cash through taxable accounts. Some say they can do better outside a 529. The question: Are they right?

Strictly by the numbers

Most of the time, no. The tax breaks usually make 529s unbeatable. Say you're in the 28% tax bracket, have a five-year-old and save $200 a month in Utah's low-cost 529, which has annual expenses of 0.38%. Assuming annual average returns of 5%, you'll have $39,100 by the time your kid is 18. Invest the same amount in a taxable account with equal fees and returns, and you'll have $36,200 after taxes. In other words, you'll lose $2,900.

The 529 comes out even further ahead if your state allows you to write off all or part of your contributions (33 states and the District of Columbia will let you do that).

As for financial aid formulas, starting in January 2009, a 529 even in your child's name will be considered a parental asset - the same as a brokerage, mutual fund or bank account in your name. So there's no reason to bypass a 529 on that score.

But wait...

All that said in celebration of 529s, expenses can easily eat away at - even cancel out - the tax savings if you're not careful. Though management fees have come down recently, some 529s are still too costly. Going back to the earlier example, put $200 a month in one of Colorado's higher-cost 529 options (1.65% fees) and, at a 5% return, you'll end up with $35,900 by your kid's freshman year; thus, the fees will wipe out the tax benefits and $300 more to boot.

Your college kitty will wind up even smaller if you buy via a broker - 529 plan commissions can be as high as 5.75%. To make your money work the hardest, buy a 529 direct and, unless you'd be giving up a generous state tax write-off, shop around for a plan with annual expenses under 0.5%, such as those run by Vanguard and TIAA-CREF.

Exceptions to the rule

There are a few cases for bypassing a 529 - a big one being that you think you might need the money for something else. If you withdraw for anything other than higher ed, you'll pay ordinary income taxes on the earnings at the beneficiary's rate plus a 10% penalty. In that case, consider a tax-efficient index fund instead. You may be similarly stuck if your child doesn't go to college. You can transfer the money to another beneficiary, but if there's any doubt about your kid's intentions, go with the index fund.

Also, if you're a fairly savvy investor, you may not want to make a 529 your first savings tool. (The investment choices within these plans are usually limited.) Instead, start with a Coverdell Education Savings Account, says Mark Kantrowitz of FinAid.org. Those who qualify (adjusted gross income of $220,000 or less for couples) can choose any investment; plus, earnings and withdrawals for various education expenses (not just college) are free of federal taxes. Under current rules, you can save $2,000 a year, but the max will drop to $500 in 2010 unless Congress steps in. As a result, the Coverdell is best as a supplement to a 529, not as a substitute.

You do the math

Compare 529 plans and fees at collegesavings.org.

Bottom line

If you're planning to save for college and have no reason to think your kid won't go, a low-fee 529 is the best savings tool - regardless of what anyone tells you.

A 529 usually beats out a taxable account earning the same return.

For more, go to cnn.com/rightonyourmoney To top of page

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