The 529

State-run college savings plans (aka 529 plans) are a great tool for parents. We tell you who should get a 529 and how to pick the right one.
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.
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.
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.


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.


How to pick the right plan

Which is the best 529 for you? No two programs are alike -- they differ dramatically in many ways, from investment choices to costs to tax breaks. Your first step should be to look at your own state's plan (if it has one). In some states you may qualify for a matching grant or scholarship. More important, many states give residents a tax deduction on 529 contributions and most exempt the earnings on withdrawals.
If your state taxes are high and your local plan offers generous tax benefits, you can stop reading here: You're best off staying at home. But if you live in a state with low or no taxes, or with limited tax breaks, then it's time to shop around. Use the following three rules as guidelines.

Shop for a manager, not a performer. Given the short track record of 529 plans, you can't glean much from the funds' performance history. So stick with plans run by investment companies with successful records managing retail mutual funds and pension plans, such as Vanguard, Fidelity, and TIAA-CREF.

Stick with low-cost plans. Expense ratios vary considerably, from less than 0.3 percent to more than 2 percent. Some states' plans are sold by brokers, which layers on additional costs. You could also pay other fees. Several states charge to open an account and tack on $25 or so in annual fees. The less you pay in fees, the more your contributions can work for you.

Look for the right investment choices, not the most. The typical 529 menu is still fairly limited. In most plans, the key offering is an age-based portfolio, which gradually shifts the asset allocation as your child ages. For children under three, for example, some 80 percent of the portfolio may be stashed in stocks. As your child grows, the equity portion shrinks so that by the time he or she is 18, the assets are held mainly in bonds or cash.

Increasingly, states are adding conventional stock and bond funds. But because you can't switch your money around freely the way you can in a 401(k), a vast number of choices isn't much of an advantage -- and is potentially riskier.
For most investors, the best choice is an age-based portfolio. In the past, these funds were criticized for being too heavily oriented toward fixed-income assets, even during the child's youngest years. But a conservative strategy is often a sensible one. "People forget that they usually have fewer years to save for college than for retirement -- most often 10 years or less, since they tend to start late," notes TIAA-CREF vice president Timothy Lane. "If you lose a lot in the early years, it's very hard to make it up."
You can also create your own stock and bond mix by opening more than one account in the child's name -- one for each asset class -- and controlling your own allocation by the amounts you invest in each. Another strategy: If you don't like the asset mix designed for your child's age, find out if you can use a portfolio for a different age. Some states let you pick your own starting point.

The most frequently asked 529 questions

Q. What's so great about 529 plans?
A. You never have to worry about annual taxes on dividends and gains, and withdrawals are tax-free too. What's more, if you invest with your own state's 529, you may get state-tax deductions on contributions or exemptions on withdrawals.

Q. Can anyone open a 529 account for any child?
A. Generally, you ("the account holder") can open an account on behalf of nearly any child ("the beneficiary"), regardless of your income. Grandparents, for example, can save on behalf of grandchildren. You can even put away money for someone who's not a family member. A handful of states open their plans only to state residents -- but most are available to everyone.

Q. Can two people open an account for the same child?
A. You can open more than one account in a single state for the same child, and more than one person can fund a 529 for the same beneficiary. No matter the number of accounts, the state's maximum contribution limit still applies to the beneficiary. States don't have to count balances in out-of-state accounts when determining whether you've met your limit, but some have started doing so.

Q. What if I need to tap the plan?
A. You can make a withdrawal anytime, but you'll pay taxes plus a penalty on the earnings -- usually 10 percent -- if the money is not used for higher education.

Q. Does my child have to go to a state school?
A. No. You can use the money at any accredited degree-granting school, whether it's private, public, undergraduate, or graduate.

Q. What kind of educational costs can the money be used for?
A. In all states, tuition qualifies. Most states also permit 529 money to be used for other costs, such as room, board, fees and books.

Q. What if my child doesn't go to college or has money left over?
A. You can take out the money, paying taxes and penalties. In most states, you can leave money in the plan indefinitely, in the hope that your child will eventually go to college. A third option is to name a new beneficiary on the account. If your child dies or becomes disabled, most states will waive penalties on withdrawals.

Q. Can I switch investment options?
A. Not without going through the rollover process described above. An easier alternative is to open another account for the same beneficiary and invest future contributions in a different fund.

Q. Can I also fund a Coverdell Education Savings Account?
A. Absolutely -- that restriction changed at the beginning of 2002. You can contribute up to $2,000 annually to a Coverdell, regardless of how much you contribute to a 529.

Student Loan Interest Deduction

Student Loan Interest Deduction

You may be able to deduct interest you pay on a qualified student loan. And, if your student loan is canceled, you may not have to include any amount in income.

The deduction is claimed as an adjustment to income so you do not need to itemize your deductions on Schedule A Form 1040.

You cannot claim the deduction if:

1. Another taxpayer claims an exemption for you as a dependent,
2. Your filing status is married filing separately, or
3. You are not legally obligated to make payments on the loan.

A qualified student loan is a loan you took out solely to pay qualified higher education expenses. The expenses must have been:

1. For you, your spouse, or a person who was your dependent when you took out the loan,
2. Paid or incurred within a reasonable time before or after you took out the loan, and
3. For education furnished during an academic period when the recipient was an eligible student.

Qualified higher education expenses are the costs of attending an eligible educational institution, including graduate school. The costs of attendance are determined by the eligible educational institution and include tuition and fees, an allowance for room and board, and an allowance for books, supplies, transportation and miscellaneous expenses.

Costs you incur have to be reduced by:

1. Non–taxable employer – provided educational assistance.
2. Non–taxable distributions from a Coverdell education savings account,
3. Non-taxable distributions from a qualified tuition program (QTP),
4. U.S. Savings Bond interest that is non–taxable because it is used to pay qualified higher education expenses,
5. The non-taxable part of scholarships and fellowships,
6. Veterans educational assistance, and
7. Any other non–taxable payments (other than gifts, bequests, or inheritances) received for educational expenses.

The student must have been enrolled in a degree, certificate, or other program leading to a recognized educational credential at an eligible educational institution and must have carried at least one half of a normal full–time work–load for the course of study being pursued.

The deduction will start to phase out when modified AGI exceeds certain amounts, please refer to Publication 970 for these limits.

If you paid $600 or more of interest on a qualified student loan during the year, you will receive a Form 1098-E (PDF), Student Loan Interest Statement, from the financial institution, from a governmental unit (or any of its subsidiary agencies), from educational institutions, or any other person to whom you had paid student loan interest of $600 or more in the course of their trade or business.

More information on student loan interest deduction and other education benefits is available in Publication 970, Tax Benefits for Education.