Saving for College: The Facts About 529 Plans

Over the past several weeks, I've been talking about how to save and invest for your retirement. But what about your children's college education? How do you save for that, too?

The bottom line is that the first step in saving for your kids' college education is saving for retirement for yourself. It's hard to face, but the facts are cut and dried: There is a great deal of financial aid available to help pay for college, but no one is going to subsidize your retirement.

But if your retirement needs are on track to be covered, or you just want to split the difference a bit (most people feel better if they're putting something away for college, even if it's a few dollars a month) one of the best places to stash your college savings is in a 529 plan.

These plans are sort of like IRAs for college: You contribute after-tax dollars, and invest the money as you see fit. Most plans offer age-based options that work like target-date retirement mutual funds, as well as ways to put together portfolios of your own. Any growth is tax-deferred, and distributions used to pay for college are free of federal taxes. Every state offers at least one of these plans; some offer several options for you to choose from. Here's what you need to know:

• Plans come in two types: prepaid and savings. Savings plans work as I explained earlier, much like an IRA or other retirement savings account. Prepaid tuition plans allow you to pay for all or some of the tuition at an in-state college in advance, locking in the current rates, which can translate to a savings -- although many of these plans struggled in the downturn, and some have stopped accepting new accounts as a result. You can generally only participate in your own state's pre-paid plan, and each has its own rules. Often, if your child decides to attend an out-of-state or private college, you can pull your money out. You may forfeit some of your balance, however, to cancellation penalties or loss of interest.

• Shop around. Start with your state's plan, says Joe Hurley, founder of Savingforcollege.com. "You may be in line for some special benefits, or income tax breaks, for using your own state's plan. But you don't have to stay within your own state -- if you see another plan that offers better investments, or lower costs, you should investigate that."

When you're comparing plans, look at investment options, performance, and fees. Hurley's website will show you a list of the best-performing plans over the past year, three years and five years. Note, these aren't guarantees. Instead, treat this process as if you were selecting a mutual fund where past performance is indicative of how well the plan is managed.

As far as expenses go, most plans will charge you a percentage of your investment. According to the Financial Research Corporation, 0.69% is typical on a direct-sold plan, which you buy yourself, as opposed to going through a broker, which averages 1.17%.

Finally, regarding investments: What you're looking for largely depends on how old your child is. If you're starting early, you want a range of equity-based investments to choose from so you can invest aggressively. If the account beneficiary is already in high school, look for more conservative options like bonds or CDs. And again, if you'd rather not be hands-on, a plan that offers an age-based option is for you. When your child is young, the plan will invest more in stocks; as he or she gets closer to college, it will shift to a more conservative allocation.

• Understand the rules. If your child decides not to go to college, you can change the beneficiary on the plan to another family member, perhaps a younger sibling. If no one ends up using the money for education, you can pull it out, but you'll pay income taxes and a 10% penalty on your earnings. If you save too much – a seemingly laughable thought, but it happens, says Hurley, particularly when investments do really well or children receive lots of scholarship money -- you can pull the money that isn't needed out and pay only income taxes; no penalty.

Finally, there generally aren't eligibility requirements, and plans have varying contribution limits, although most are fairly high: $300,000 per beneficiary, sometimes more. More important to note, says Hurley, is the annual gift tax exclusion of $13,000 ($26,000 for married couples), because contributions to 529 plans are considered gifts. However, you can front-load your contributions for five year periods, meaning you can contribute, say, $65,000 in one year, then wait four years before contributing again. This allows your money more time to grow.

One last note: Your decision to select a specific plan isn't irreversible. If you pick one and decide you're unhappy with its performance, you can roll over to a different plan (you can do this once every twelve months if you need to). And if you decide you've gotten too aggressive with your investments, or perhaps too conservative, you can change your investment options once every calendar year as well.