The 529 Basics

Updated on January 9, 2008.

WHEN CONSIDERING A 529 plan, the first thing you need to know is that these plans come in two flavors: "prepaid college tuition plans" and "college savings plans." We'll admit, we're pretty partial to the latter (for reasons you'll understand as you read through this package). But a perk of both plan types is that they are open to anyone, regardless of income — unlike, say, a Coverdell Education Savings Account (CESA), which excludes joint filers with adjusted gross incomes (AGIs) above $220,000 and single filers with AGIs above $110,000.

With CESAs you can contribute up to $2,000 annually to an account, which like an IRA, you can then invest however you choose. Sounds pretty good until you consider that the Coverdell contribution limit is peanuts compared with what you can contribute to a 529 plan. Most of the state plans let you contribute more than $230,000 and some (like Alabama's Higher Education 529 Plan) allow a maximum contribution of $300,000 that can then grow tax-free. Beneficiaries can be changed without income-tax consequences to family members of original beneficiary, including cousins.

But before you plunk down your cool quarter-mil, there are still tax issues to consider. For starters, while future withdrawals will be federally tax free, you might owe gift tax if you contribute more than $12,000 annually. That's because anything you contribute over that amount reduces your $1 million lifetime exclusion. Keep in mind, however, that both you and your spouse can each make $12,000 contributions in a given year. In fact, if you've got the cash on hand, you could even make five years' worth of contributions upfront, provided that you don't make any other cash gifts to that beneficiary over the next five years, explains CPA Tom Ochsenschlager, a partner at Grant Thornton. That means you and your spouse could contribute up to $112,000 in one fell swoop without negative gift-tax consequences. Grandparents can get in on the act too, which can be especially strategic if they're looking to reduce their estate-tax liability.

Finally, unlike UGMA and UTMA accounts (which are essentially custodial accounts set up for minors), 529 plan contributions are not irrevocable, explains Craig Bramhall, regional vice president of investment products at American Express, which is affiliated with Wisconsin's college savings plan. In other words, should Junior decide to become a circus acrobat rather than go to college, with a 529 plan you can simply change beneficiaries to someone else in your family. With an UGMA or UTMA, on the other hand, once Junior is legally viewed as an adult by your state, he could take the money and start his own circus.

Finding the Right Plan
The first step in finding the right plan is to decide between a prepaid and college savings plan. We lean strongly toward college savings plans, which offer you much more flexibility — both in terms of investments and how you spend your money.

The next step is careful research, but fortunately, you have an excellent crib sheet. Joe Hurley's Web site, Saving for College will give you the lowdown on each state's plan, including maximum contributions, eligibility requirements, performance information and contact information. It's an invaluable resource for finding what you need.

Here are some other things to consider: