Saving for College 101: State-Sponsored College Savings Plans

Saving for your children's college education is one of the most important financial tasks you will ever undertake. Luckily, you have plenty of savings options, most of them with tax advantages designed to encourage you to invest in your children's future.

529 Savings Plans

These state-sponsored investment accounts, named after the section of the tax code that gives them tax-favored status, let you shelter your college savings from federal (and usually state) income tax. You don’t get a federal tax deduction for your contributions to the account, but your investments grow tax-free, and the earnings escape tax altogether if you use withdrawals to pay for qualified educational expenses—such as tuition, fees, room and board, and textbooks.

If your child decides not to go to college, you can switch the account to another family member, such as a sibling, and preserve the tax benefit. Or you can cash in the account and use the money for whatever you want, but you’ll owe tax and a 10% penalty on the earnings.

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Depending on where you live, you may also get a state tax deduction or tax credit as a reward for your contribution to these qualified tuition programs. About two-thirds of the states and the District of Columbia allow you a state tax deduction or other tax benefit as an incentive to save for college. Arizona, Kansas, Maine, Missouri and Pennsylvania even give you a deduction if you contribute to a plan in another state, and a number of states let you take a deduction on contributions you make to someone else’s account. In Virginia, account owners themselves can take a deduction on contributions made by someone else, such as a grandparent.

Once you select the portfolio you want, an investment firm chosen by the state manages the investments for you. You can switch portfolios within the plan or transfer the money to another 529 account once a year. Unlike other education-savings programs, 529s let you participate no matter how much you earn, and the states set generous limits on total contributions—in many cases more than $300,000.

You’ll likely have a choice of two kinds of accounts: those that you invest in directly and those that you can purchase only through advisers or brokers. Broker-sold plans tend to be more expensive than direct-sold plans because they carry sales charges as well as management fees, but they also offer more investment options. Still, you can find a decent investment selection in a direct-sold plan, and the lower expenses mean that more of your money will go toward building the college fund.

Which plan is best? If you live in one of the states that offer a deduction or a tax credit, your savings on taxes likely will overcome any shortcomings of your state’s 529. If you don’t get a tax benefit from your state, shop around; most state plans are open to residents and nonresidents alike. Look for programs that have plenty of investment options, and compare administrative and management fees, which vary widely. To find links to plans in your state, visit www.savingforcollege.com.

Stashing money in these accounts will not unduly affect your student’s chances for financial aid. According to the federal financial aid formula, parents are expected to contribute a relatively small amount — up to 5.6%, after subtracting an allowance for living expenses — from savings to the college bills.

Prepaid-Tuition Plans

Prepaid tuition plans let you buy tuition at a state college or university years before your child is ready to attend. That can be an attractive idea when tuition is going up faster than the rate of return you’re likely to make on your investments (obviously, it’s not so great when the reverse is true). One thing is certain: The plans give you the satisfaction of knowing that the college bills will be covered down the road.

Prepaid plans come in three varieties: contract plans, in which you pay upfront to cover tuition and fees for a semester or a year; unit plans, in which you buy units equal to a portion of the average annual tuition and fees at your state’s public institutions; and voucher plans, which let you buy certificates that you redeem for a percentage of tuition or fees at participating public institutions. The Private College 529 Plan offers a comparable program for more than 270 participating private institutions.

With most prepaid plans, only state residents are eligible to participate. Typically, you pay a lump sum upfront or pay over time in installments. You must usually buy in to a prepaid plan at least three years before your student will be ready to enroll. States typically charge somewhat more than that year’s tuition and fees to ensure that they have enough money in reserve to cover future costs. If your child ends up going to school beyond state borders or to a private school, the plans let you apply the value of your account (usually a weighted average of the costs at the in-state public universities) to that school. You can also take a refund, which may include a small amount of interest. Check with the plan for details.

State-sponsored prepaid programs are not for everyone — literally. Only about a third of the states offer the programs at all, and several of those states have closed their plans to new investors.

The amount you have accrued in a prepaid plan (that is, the amount that would be returned to you as a refund) is assessed up to 5.6%, according to the federal financial aid formula.