529 Plans for College

To maximize savings for their children's education while minimizing taxes, many folks are using Coverdell ESAs and custodial accounts. Here's another good option: the 529 plan.

A 529 plan allows you to either prepay tuition for qualified colleges or save funds in a tax-free account to be used to pay higher education costs. You can do this for any child in your life - your kid, your grandkid, or the kid next door who mows your lawn. (If you're going back to school, you can even set up a 529 plan for yourself!) You don't necessarily have to live in the state of the plan that you choose, either.

529 plans allow you to sock away huge sums of money - more than $200,000 in some states - versus the maximum annual Coverdell ESA contribution of $2,000. Most 529 plans have no age or income limitations, so higher-bracket taxpayers can participate. Another big advantage is that the person who establishes the account decides when distributions may be taken.

There are no taxes on earnings in a 529 plan, so you can build a big war chest much faster than if you had to pay taxes on the investment gains and income every year. Though your contributions are not tax-deductible, when withdrawals (including earnings) are used to pay for qualified college expenses, they're free of federal taxes.

There are some drawbacks to 529 plans. If the student doesn't go to college, there may be a 10 percent penalty on the earnings, depending on the circumstances (though you can also change the beneficiary if that happens). Additionally, the funds in the 529 plan account are handled by plan administrators, not by you - which is actually a plus for some folks. Finally, once the money is in the plan, it must stay there or in another 529 plan.

Still, 529 plans are many people's best bets. Some are much better than others, though. Learn more about them and other college financing topics at www.savingforcollege. com, www.collegeboard.com and www.fool.com/college.