529 Plans Make a Money-Saving Comeback

serious students listening...

As the costs of college education have risen steadily over the years, families have realized that they need to do what they can to help their kids avoid a mountain of student-loan debt once they graduate. One of the most popular ways that Americans have saved for college is through 529 plans, also known as college savings plans. Back in January, though, the future of 529 plans was in peril, as President Obama's budget included a provision that would have endangered the use of college savings plans as a viable way to save more for college education.

Backlash against the budget proposal was extremely strong, leading to its removal from the administration's budget. Now, lawmakers have taken action to make 529 plans an even more useful tool for savers. Below, we'll take a look at why 529 plans were under threat and what the government is not trying to do to strengthen college savings plans for the future.

Taking Away a Key Tax Break

The most important element of the 529 plan is that it allows you to save money in a special account that is free of tax. Not only do you avoid having to pay income taxes on the interest, dividends, and investment appreciation on your holdings within the 529 plan throughout your children's pre-college years, but you also get to make tax-free withdrawals of those earnings as long as you spend the money on qualified educational expenses.

The administration's budget proposal sought to take away the tax-free feature of 529 plan withdrawals used to pay for a college education. Instead, the earnings that 529 plan accounts collected would be subject to income tax when they were withdrawn, in a manner similar to how traditional IRAs for retirement get taxed. Taxpayers would get credit for the after-tax money they had used to contribute to the 529 plan in the first place, but they'd have to pay taxes on any rise in the account's value resulting from investing those contributions.

The changes would only have applied to new 529 plans, but in response to loud criticism from the public, the administration withdrew its proposal on 529 plans. Now, though, lawmakers have started work on measures that would enhance the value of the college savings plans.

Making 529 Plans Even More Useful

Late last month, the House of Representatives passed H.R. 529, a bill aimed at expanding college savings plans. If it passes, the bill would make some major enhancements to 529 plans going forward.

First and foremost, the bill would expand the definition of qualifying educational expenses to include computer equipment and software as well as Internet access for students to use while in college. Currently, you're only allowed to withdraw money tax-free for tuition and other fees required by the college or university, as well as materials like books that are specifically required for the coursework the student does. Room and board also qualifies as long as the student is enrolled at least half-time, but most furnishings and other optional costs don't qualify.

Second, the bill would remove an onerous and largely outdated provision of 529 plan law that requires parents to add up the money they take out of multiple plan accounts and perform certain calculations to determine whether any of the money is subject to tax. Under current law, those provisions rarely apply, but the bill would ensure that even if the tax-free nature of 529 plans comes into question again in the future, savers wouldn't have to deal with the complication of coordinating multiple accounts for tax purposes.

Finally, the bill would allow parents who get refunds from colleges and universities to put that money back into a 529 plan account. Parents would have 60 days to get the refunded money back into the 529, closely mirroring what retirement savers are allowed to do with rolled-over IRA withdrawals.

Be Smart About College Savings

The passage of H.R. 529 is far from assured, despite the House's 401-20 vote in favor of the measure. Despite a veto-proof majority, the Senate still has to consider the bill, with possible amendments that could change its provisions.

Nevertheless, with 529 plans having survived the threat of having their tax-free nature taken away, college savers can still benefit greatly from using college savings plans under current law. Any added provisions making them even more attractive would just be icing on the cake for parents looking to do their best to support their children's education.

Motley Fool contributor Dan Caplinger isn't looking forward to his 10-year-old's future fight with financial aid offices. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.