Lightening the tuition load doesn't get much easier than with 529 plans, which allow families to stash college money in an account where it can grow and compound tax free. Named after a section of the tax code and offered through states, 529 savings plans encourage parents to start socking away money early. "That's what they do better than just about any financial vehicle out there," says Jackie Williams, director of Ohio's 529 plan and spokeswoman for the College Savings Plan Network. "Think of a 529 as a road map for financing college."
It's a road map with tax advantages. Just as in a 401(k), money in a 529 can grow and compound free of federal taxes (these tax breaks permanent, thanks to the Pension Protection Act of 2006). As a bonus, some states extend their own tax breaks, and the most generous offer incentives like matching contributions for low-income families. Withdrawals from 529 plans are also exempt from federal (and sometimes state) taxes, as long as the money goes to qualified educational expenses, such as tuition and room and board. Nonqualified 529 withdrawals are taxed as ordinary income and are subject to a 10 percent penalty. If parents set up the account, the money held in a 529 plan is considered a parental resource in calculating financial aid.
There are two types of 529s: traditional college-savings plans and prepaid-tuition plans. College-savings plans, the most common, are like mini 401(k)'s: You invest in a basket of mutual funds, and the earnings grow tax free. All states offer at least one 529 savings plan, although Tennessee's will shut its doors in May because of years of low enrollment and poor returns. State plans are typically managed by mutual-fund companies. You aren't limited to your home state's plan, although you may be giving up state-level tax breaks if you opt for greener pastures. "These plans are portable, so you can select one managed by a particular mutual-fund company or one with a low minimum investment," says Williams.
Getting started isn't as expensive as you might think. Ohio, for example, will allow you to enroll in a 529 for just $15. California asks for $50 upfront or $15 a month if you agree to contribute regularly. Each state plan offers its own menu of investments: Some include age-based portfolios that shift to become more conservative over time, while others ask you to choose from a static mix of funds that range from conservative to aggressive. Each plan carries investment risk; the value of your plan is dependent on the performance of your investments. Steep expenses can put a significant dent in long-term returns, so pay attention to fees, which range from management to administrative fees (not to mention commissions, if you're investing through a broker). The good news is that state plans are getting more attractive, with lower fees and more investment options, says 529 guru Joe Hurley, who runs savingforcollege.com. "This is a competitive and sensitive area for states, which want to make sure their plans are as keen and advantageous as possible," he says.
With prepaid-tuition plans, the idea is to lock in future college costs at today's prices. When you invest in a prepaid plan, you usually buy a chunk of in-state tuition, which could be one semester at a community college or five years at a university. Each state has its own plans and residency requirement.
By design, prepaid plans are guaranteed to increase in value at the same rate as tuition inflation. Tuition and fees at public four-year colleges and universities have risen at an average of 7 percent a year over the past decade, according to the College Board. So if $1,000 goes in a prepaid plan for a newborn today, the money would cover $3,380 worth of college costs in 18 years, assuming the rate is unchanged.
Prepaid plans also have their drawbacks. Some state plans are restricted to residents, and only 13 states currently offer them. Also, prepaid plans usually cover only tuition and mandatory fees (although some states, such as Florida, offer separate plans that cover local fees and dormitory housing).