What they are
Section 529 plans are state-sponsored mutual funds that allow you to invest in the financial markets for the exclusive purpose of saving for college, without having to pay taxes on your earnings, explains Stillman. Normally, if you make money on any investment -- including real estate -- you have to pay capital gains taxes. The amount of these taxes can be anywhere from 8 to 20 percent of your earnings.
Another benefit of 529s is that in most cases, they won't hurt your child's chances of getting financial aid. A major factor in financial aid is how much money is set aside in the student's name; the more money he has, the less likely he is to get aid. These accounts designate the parent as the owner of the account, so the money is deemed a parental asset, which carries less weight in determining aid.
To offer 529 programs, each state has partnered with an investment firm that sets aside one or more mutual funds exclusively for college savings, says Stillman. If your child decides to forego college, you can transfer the money to another child. However, it has to be used for someone's college expenses only, or else it's subject to taxes plus a 10 percent penalty, warns Steve Vitale, a certified financial planner at J.B. Hanauer & Co. in Parsippany, New Jersey.
You can invest in any state you want, but many states offer tax advantages to residents who keep their money close to home. For example, some states will let you deduct the amount of your yearly 529 contribution from the amount you owe that year in state income taxes. Conversely, investing out of state could cost you some tax penalties.
A 529 plan can be made up of stocks, bonds, or a combination of both. Some states even have age-based mutual funds that give high-risk, high-return stocks to people whose young children have time to spare before college starts. The money is automatically transferred to safer securities as the child gets closer to college age.
What you should know
There's always a risk when you decide to invest in the financial markets. Sure, that risk is lower if you keep the money in longer, but gains are never guaranteed. What's more, all 529s are not created equal, says Vitale. It's like any investment -- it's important to take the time to do your homework. For example, in the last quarter of 2002, on average, Illinois' plans yielded about 4 percent. Other states, such as Massachusetts, wound up in the negative numbers.
While historical rates of return are not a guarantee of future 529 performance, they can give you some indication of the company's track record. Vitale suggests asking either your financial adviser or the 529 management company about the fund's past performance. Also, review the management's brochures so you know who's handling your money. You may also want to consider seeking the advice of a professional financial adviser; it may cost extra now, but it's likely to pay off in the long run.
Another potential issue with the 529 plan is that it may be retired in September, 2010, well before today's toddlers are filling out application forms, says Kalman Chany, author of Paying for College Without Going Broke (Princeton Review). There's no way to know what Congress will decide in 2010, but many financial experts are betting it will renew the program, because making it more difficult to save for college would be an unpopular decision. Chany, meanwhile, isn't so sure. If the law expires before your child is in college, you'll have to pay taxes on all that money.
What you need to start
You only need $25 to open an account in most states. And each parent can contribute as much as $55,000 every five years, says Vitale. Over the life of the plan, you can give between about $140,000 and $350,000, depending on which state you've selected. First, contact your state treasurer at www.collegesavings.org to find out which investment company is running the program, and research other states at Web sites such as Savingforcollege.com or 401kid.com. Before making a decision, be sure to review the historical performance of the fund and find out about tax penalties and benefits.