2. Who should get one
So how do you know if a 529 is for you? Shortcomings and all, 529 plans are a hard-to-beat way to boost your college savings -- provided you meet one of these four criteria.
You're in an above-average federal tax bracket, with time to save. The critical advantage of 529 plans is tax-deferred compounding. The higher your tax bracket and the longer your time horizon, the greater the benefit of tax-sheltered compounding.
In theory, you could build a tax-efficient college savings portfolio without a 529: Simply buy and hold top-quality individual stocks or mutual funds that keep taxable distributions to a minimum. That way, you won't pay taxes until you need your money.
The problem, however, is that as your child nears college age, you should start shifting savings out of stocks and into lower-risk bonds and cash. All that asset shifting triggers tax bills -- something that doesn't happen with 529 plans. "The real-world advantage of investing tax-sheltered in a 529 beats the theoretical advantage of investing for low capital-gains taxes," notes Raleigh, N.C. financial adviser Brian Orol.
When you compare a 529 plan with a balanced fund that shifts between stocks and bonds, the tax advantages are obvious. According to TIAA-CREF, an investor in the 31 percent tax bracket who saves in a 529 plan for 18 years would come away with 20.5 percent more than someone who puts the same amount in the typical taxable balanced fund.
You are unlikely to qualify for need-based financial aid. As adviser Raymond Loewe of College Money, a planning firm in Marlton, N.J., puts it, "The tax savings you get in a 529 plan blow up when it comes time to qualify for aid."
Here's why. Under financial aid formulas, 529s are counted as the parents' asset until you withdraw the money. And parents' assets are assessed at the lowest possible rate for financial aid purposes. But gains from a 529 count as the student's income, up to 50 percent of which is considered available to pay tuition.
All this means is that anyone who might need a lot of aid is better off saving outside a 529.
What if your financial situation changes after you've begun funding a 529? If you later find yourself in a position where you are likely to be eligible for financial aid, try and wait to take withdrawals from your child's 529 until the last year of college, when it won't be counted against future financial aid.
You live in New York, Michigan or another high-tax state with significant 529 tax breaks. If your state offers a generous tax deduction on 529 contributions, take a serious look at the plan even if you are in a lower tax bracket. In New York, for example, residents earning more than $40,000 are taxed at a rate of 6.85 percent; if you live in New York City, add on 3.78 percent. The state's 529 plan, run by TIAA-CREF, offers a state-tax deduction on contributions of up to $10,000 per household a year (no matter the number of kids), which can save New York City residents as much as $2,038 a year.
You're a grandparent looking to reduce your estate. You can deposit up to $55,000 ($110,000 for a married couple) into a 529 plan without incurring the federal gift tax, making 529s an ideal way to move a big sum out of your estate quickly. A $55,000 contribution is counted against your $11,000 annual gift exclusion over five years, so you won't be able to make another tax-free gift to that beneficiary for six years.
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