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Bankrate's 2009 Tax Guide
Take some of the sting out of the ever increasing cost of college by applying these tax-favored options.
529 tax breaks now permanent
Pension law: permanent 529 tax exemption

Dear College Money Guru,
I have heard that Congress made the tax exemption for 529 plans permanent. Is that true, and what does it mean for those of us who are weighing whether to go with a 529 plan versus other types of savings to fund education?
-- J.W.

Dear J.W.,
You heard right. Buried among the 900-plus pages of the Pension Protection Act of 2006, passed by Congress and signed into law by President Bush on Aug. 17, 2006, is a single sentence that removes the 2010 expiration of the 529 tax exemption.

This new development should come with a sense of relief and excitement for all families with children. A 2001 tax law -- Economic Growth and Tax Relief Reconciliation Act, or EGTRRA -- made withdrawals from a 529 plan completely tax-free when used for college, but established a "sunset" date of Dec. 31, 2010. Ever since then, I've been trying to assure investors that Congress would eventually defuse the time bomb. But assurances are not the same as guarantees. Now that it's actually happened, 529 plans will no doubt see a surge in contributions.

While 529 plans are not necessarily the best choice for every college saver in every situation, they must be placed high on everyone's list of alternatives. The federal tax benefits are difficult, if not impossible, to beat. And most states tack on additional incentives, including state deductions for contributions and, in some cases, matching contributions. Of course, it's up to you to select which 529 plan(s) to use, and within any 529 plan you'll have a menu of investment options from which to choose. Prepaid tuition plans also qualify for 529 tax treatment.

Taxable mutual funds become relatively less attractive as a college-savings vehicle. Sure, you have thousands to choose from and you won't be at risk for the tax and 10 percent penalty incurred on 529 withdrawals not used for college. But any earnings are subject to tax, and they can also have a substantial impact on financial-aid eligibility. Even if the gains are eligible for the low tax rates on capital gains and dividends, you should be prepared to see these rates increase in 2011.

Thinking about gifting those funds to your child and shifting the gains onto his or her return? Think again. The "kiddie tax" could foil those plans. This law was created to prevent asset shifting from parents to their children in lower tax brackets. Congress has been steadily reducing this option by raising the age at which the "kiddie tax" applies. Currently, youngsters 18 or younger, or 23 or younger if they're full-time students, will be subject to the kiddie tax.

How about Coverdell education savings accounts, now known as education savings accounts or ESAs? You really can't go very far with them. Even if you see a way to save on expenses -- 529s generally charge a modest management fee -- you'll be giving up any state income tax deduction that may come with your state's 529 plan. You're also be facing age and income restrictions and a $2,000 per child annual contribution cap. What's worse, ESAs are still facing a 2010 sunset on several important changes made in 2001. Because of that sunset, you'll probably decide to roll over your ESA balances into a 529 plan at some point anyway.

If you're confident you'll be using the money for college, you can't go wrong with 529 plans. Take the time necessary to learn the rules -- they're not all that difficult. Then focus your efforts on finding the 529 plan that best meets your own preferences and objectives.

-- Updated: Jan. 7, 2009

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