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First the grim news: The cost of a college education has continued to increase at rates well above the general inflation rate in recent years. Now the good news: Your options for setting aside college money in tax-efficient investment accounts have increased as well. We’ll examine three of the most popular: 529 plans, custodial accounts and Coverdell accounts. The Lowdown on 529 Plans Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions. College savings plans—a type of 529 plan. Many of these plans are national plans: no matter which state or school sponsors them, residents of any state can participate.
The potential advantages of 529 plans include:
• Tax-free earnings – Earnings in a 529 plan accumulate free from taxes, and qualified withdrawals are federally tax free. Withdrawals may be exempt from state taxes as well (tax rules vary from state to state). Nonqualified withdrawals from a 529 plan may be subject to income taxes and a 10% additional federal tax.
• Gift tax benefits for contributors – A contribution to a 529 plan is considered a gift for federal tax purposes.
• Generous contribution rules– Lifetime contribution limits on 529 plans vary from state to state, but often exceed $200,000 per beneficiary, including earnings. In addition, there usually are no income restrictions on contributors to a 529 plan.
• Account control – The individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account. This is not the case with Coverdell Education Savings Accounts or certain types of custodial accounts. Account owners may also change beneficiaries.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing. Withdrawals for expenses other than qualified education expenses are subject to income tax and an additional 10% penalty on earnings.