529 College Savings Plan

NEW YORK (MONEY Magazine) - Named after a section of the tax code, 529 college savings plans allow just about anyone to save for college on behalf of anyone else. Your contribution isn't deductible on your federal tax return, but in 26 states you can write off at least a portion of what you save.

Earnings grow tax deferred and withdrawals are tax-free if you use the money on qualified education expenses. (One caveat: Unless Congress renews tax-free withdrawals -- legislation is pending -- earnings would be taxed at your child's tax rate when you take money out of the plan after 2010.)

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.

Each program offers an array of stock and bond funds. But one of the best features of 529 plans is the so-called "age-based" portfolio.

These preset fund mixes automatically shift from stocks to fixed income as your child approaches college age -- which is ideal for investors who prefer a simple buy-and-hold approach.

"Most investors are choosing age-based portfolios," says Joe Hurley, head of Savingforcollege.com.

One of the problems with 529s is that there are 85 separate state plans. Fifteen states offer more than one 529 savings program (Arizona has five). To settle on a single choice, follow these steps using the table (from which we've eliminated small and duplicate plans) and our picks as your guide.

If you live in a high-tax state that offers a generous deduction for 529 contributions -- New York and Michigan, for example, allow write-offs of up to $5,000; $10,000 if you are filing jointly -- your hometown 529 may be a can't-miss deal.

In the table, we highlight 14 plans that are good bets for state residents (based on tax breaks, expenses, fund choices and investment management).

If, on the other hand, your tax rate is low -- or your state doesn't offer a deduction or even levy an income tax -- there's no reason not to shop nationally. So we also single out five 529 plans that are good for national shoppers too.

Nothing is more certain in investing than the toxic effect of high expenses, and too many 529 plans charge too much.

This is especially true of programs sold by advisers. The funds in Alabama's Higher Education 529 Plan, for one, have annual expenses of as much as 2.82 percent. Focus instead on plans that charge 1 percent or less, such as Utah's Educational Savings Plan (0.4 percent).

Keep in mind that the same fund company may charge differently in different states. TIAA-CREF, for example, operates 12 similar plans. But annual charges range from 0.65 to 0.85 percent. Unless you're getting a local tax break (say, in Idaho), there's no reason to pay more than 0.65 percent for a TIAA-CREF 529 (the Michigan plan).

In addition, it's important to look at individual fund expenses. If you live in Ohio and go with the local Putnam plan, make sure you pick the Vanguard funds that are offered, which charge no more than 0.49 percent vs. 1.42 percent for the Putnam funds.

Don't be overly swayed by a 529's performance history. For one thing, the track record may be short (most plans are no more than four years old).

Your best strategy is to stick with well-established fund companies that have a history of consistency and shareholder responsibility. Our top picks are run by Vanguard and TIAA-CREF, which have a record of keeping expenses reasonable.

Unless you want to adjust your kid's stock-and-bond mix annually -- which is important to do for a relatively short-term goal like college -- make sure your plan has an age-based option. Some 529s have more than one age-based fund, giving you a choice of risk level, from conservative to aggressive.

Okay, you've picked a plan and mastered the basics, but managing a 529 can be awfully confusing. Remember the following rules.

Anyone can open a 529 account. Parents, grandparents, generous friends -- any of them can fund a 529 on behalf of nearly any child, regardless of income. To qualify for a deduction on your contribution, you have to live in the state that's offering the plan. (Some states limit the deduction to the person who opens the account.)

You can also open more than one account in a single state for the same child. Adults who intend to return to college can take advantage of 529s too, although some states have age restrictions. You can even open an account on your own behalf in many states.

Most college costs count as "qualified" withdrawals. You can spend 529 money on tuition, fees, books and supplies at any accredited, degree-granting college in the country, whether private or public, undergraduate or graduate.

In most cases, you can use the money for room and board as long as the student is enrolled on at least a half-time basis. If your child has disabilities, you can tap a 529 for special-needs equipment or tutoring.

You can switch funds or even move to another 529 plan. Under IRS rules, you can reallocate investments within a plan -- but only once a year. (That's one reason age-based funds, which shift the allocations automatically, are so popular.)

You can also move your money into a new plan once a year. Some programs may charge a fee, and a few impose a minimum holding period -- New Mexico, for example, has a one-year waiting period for rollovers. Plus, some states, including Colorado and Nebraska, tax rollovers to out-of-state 529 plans in order to recapture the tax breaks you've already received.

If your child doesn't go to college or doesn't need the money, you won't lose it. You can get a full refund, but you'll pay taxes plus a 10 percent penalty on your investment earnings. If your child becomes disabled or dies, the plan will waive penalties. In the lucky event that your child receives a scholarship, it will waive penalties on withdrawals up to the scholarship amount.

An alternative would be to leave the money in the account as long as the state permits -- perhaps your child will go to school, or graduate school, later. You can change the plan beneficiary as long as you select a "member of the family," which means you could pay tuition for a sibling, step-sibling, cousin or aunt.

More college savings plans: The 529 alternatives

Getting started saving for college: Build an A+ college savings plan