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Educational Funding: 529 Plans
 
529 Plans

State 529 College Savings Plans
These plans, named after the section of the tax code that governs them and run by the states, let you save large amounts of money tax-free, usually in mutual funds. Investors have flocked to these plans since they became exempt from federal taxes in 2002, pouring nearly $26 billion into accounts through the end of June, up from $19.2 billion at the end of 2002, according to Financial Research Corp.

Those in high tax brackets are likely to get the biggest bang for their money because there are no income restrictions to contribute and the plans maximize tax savings. Still, with more than 80 plans now available, choosing the plan that's right for you can be bewildering. A good first step: Check out your own state's plan, which may offer you a state tax deduction for your contributions. Potential downsides include high fees and limited investment options. Moreover, you can adjust asset allocation only once a year or when you change beneficiaries. On the upside, because these plans are typically held in the parents' name, they have a relatively small effect on financial aid.

529 Prepaid Plans
Although state prepaid plans have gotten a bad rap these days, they may be worth considering if you don't want to worry about fluctuating investments and you are confident your child will attend one of your state's public schools. These plans let you buy future tuition at local public colleges at today's prices. But budget cutbacks have forced many state schools to raise tuition while the assets used to finance the plan benefits have dwindled with the stock market. As a result, more plans have been forced to impose fees, temporarily halt enrollment or boost prices. Moreover, payouts from these plans reduce aid eligibility dollar for dollar.

Independent 529 Plan
This new prepaid plan works like the state prepaid plans, but parents will be able to lock in tuition at a group of more than 220 private colleges at slightly discounted rates. The new plan should appeal to conservative investors, families who strongly favor private colleges over public schools, or private-college alumni who would like to see their kids attend their alma maters.

Ron Kleopfer, a retired orthopedic surgeon from Cody, Wyo., with seven grandchildren, said he's interested in the plan, in part because his older three grandchildren are "exceptional students" who are likely to go someplace other than a state university. Although one of the big risks is that your child won't attend one of the participating colleges, you can get your money back, adjusted slightly for fund performance. Parents can also roll over the money without penalty to another beneficiary or to either a state 529 savings or prepaid plan. Like state prepaid plans, distributions reduce your aid eligibility dollar for dollar.

Coverdell Education Savings Accounts
Formerly known as the Education IRA, the Coverdell Education Savings Accounts let families with adjusted gross incomes of up to $220,000 save up to $2,000 a year tax-free for education expenses (for single filers, the income cap is $110,000).

"It's a very good entry-level college savings plan," said Brian Oral, a planner in Raleigh, N.C., because it works for families who can afford to save only a little bit each month and for those who plan to use the funds to pay for private elementary and high schools. The big appeal of Coverdells is you have a lot more investment options than 529s. However, Coverdell savings count against you when schools award financial aid because they are held in the student's name.

Savings Bonds
Middle- to low-income households seeking a safe investment may want to consider savings bonds, such as Series EE bonds issued after 1989 and all Series I bonds. For married taxpayers with adjusted gross incomes of $117,750 or less ($73,500 for single filers), some or all of the interest earned is tax-free if used for higher-education expenses. If your child doesn't go to college, you won't be penalized for using the proceeds for something else, though, of course, you won't get the tax break. The rub with savings bonds are low returns. The current rate on EE Series savings bonds is just 2.66%. That's why many people will do better with potentially higher-return investments like stocks to keep pace with rising tuition costs. The good news: Because savings bonds are typically purchased by the parents (or those who are least 24 years old or older), they usually have little effect on how much aid you'll get.

Taxable Accounts
By investing money for your children in a regular brokerage account, you will have greater control, unlimited investment options, and the flexibility to use the money for any purpose. Plus, the new tax law, which cut the top tax rate on capital gains and dividends to 15%, makes the tax bite less onerous. Like savings bonds and 529 savings plans in the parents' names, taxable accounts have little effect on how much financial aid you'll get.

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