To encourage families to start saving early for college, all states now sponsor what are commonly called 529 plans. Named after the section of the federal tax code that allows them, they offer significant tax benefits.
There are two basic types of 529 plans: savings plans and prepaid tuition plans. The more popular is the savings plan.
With a 529 savings plan, parents open an account and choose an investment strategy. Earnings accumulate tax free and withdrawals can be made tax free, when it's time to pay for a child's college expenses including tuition, books, and room and board.
How it works
Money from a state-sponsored college savings plan can be used to pay for educational expenses at any accredited college or university.
Each savings program offers parents several different investment choices. Because many state programs are open to nonresidents, it makes sense for parents to shop around for a plan that best meets their financial and educational needs.
A popular type of college savings plan begins with some aggressive investments and grows more conservative as the potential college student grows up.
Many plans allow anyone -- from any state -- to contribute to a 529 plan. If you start a 529 account for your child in your home state, grandparents or even friends can contribute to it, even if they live across the country.
For example, if you start a 529 plan in Minnesota, relatives or friends who live in Oregon can still contribute. The caveat is that some states may charge residents a tax on earnings on out-of-state 529s.
So you've planned ahead for your child's education. What happens if a potential college student decides not to go to college?
Some parents hang on to the 529 plan in case the child decides to attend university at a later date. Others transfer the account over to another family member.
Some parents decide to cash out the plan and pay a penalty. Most states collect a penalty of 10 percent of the earnings on any withdrawal that is used for non-educational purposes.
A federal penalty equal to 10 percent of earnings will be charged as well. No penalty will be assessed if a beneficiary should die or become disabled.
While the tax-free withdrawals clearly make 529 plans attractive financial options, they may not be right for every family. The reason? Participating in a 529 plan affects a family's eligibility for financial aid.
Who can benefit from a 529 plan?
Some financial advisers urge lower-income families, who are likely to receive a large amount of financial aid, to pass on 529 plans. If you're likely to qualify for financial aid, the existence of a 529 savings plan may reduce or eliminate the amount of aid you can receive. That's because for financial-aid purposes, savings plans are considered an asset of the account owner.
If the parents hold the plan, the amount of financial aid the student may be eligible for will be reduced by up to 5.6 percent of the savings account. A family with $40,000 in a 529 savings plan, for example, would see their financial aid decrease by as much as $2,240.
College savings plans may make the most sense for upper-income families who won't qualify for financial aid and for middle-income families who qualify for loans and little else.
529 plan Risks
While a state-sponsored plan has benefits, the costs may be higher than you think. Invest in a high-priced plan and you'll lose a nice chunk of earnings to hefty management expenses and other fees.
Let's say your family contributes $600 a year to a college savings plan with a $50 annual maintenance fee. And let's suppose an 8 percent return. By year's end the account balance would swell to $648. But that $50 maintenance fee would knock it back down to $598. So after a year of investing, you've got $2 less than when you started.
A key advantage of a 529 plan -- tax-free earnings -- matters little if fees eat up all or most of your earnings.
The good news is many college savings plans will waive annual maintenance fees to in-state residents, people who make automatic contributions and people with large account balances, often $25,000 or more.
The bad news? There are plenty of other fees to worry about. Several college savings plans charge you a one-time enrollment fees right from the get-go. These fees range from $10 to $90, and most are under $50.
Asset-based management fees
The most troublesome fees for families stretching to save for college are fees that are charged every year, such as an asset-based management fee. This fee represents the operating expenses of the college savings plan and is charged as a percentage of the plan's assets each year.
A 1 percent, asset-based management fee means that a fee equal to 1 percent of the plan's assets gets deducted each year. A 5 percent asset-based management fee means a fee equal to 5 percent of the plan's assets gets deducted each year.
The higher the asset-based management fee, the more earnings get swiped out of your account every year.