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529 Plans Saving For College With Tax-Deferred Accounts

written by: Brian Nelson•edited by: Rebecca Scudder•updated: 6/29/2011

The cost of attending college continues to rise much faster than the rate of inflation. Government aid can’t keep up with the cost of tuition either, and scholarships are getting more competitive every day. How smart saving for college strategy can help.

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    Saving For College

    Saving for college sounds simple enough. Start saving money for a child when they are born and by the time they are ready to go to college there will be a nice big nest egg for them to use to pay for tuition and other expenses with. Unfortunately, the reality is much harsher.

    College tuition has risen an average of 7% per year and shows no signs of slowing. At that rate, a $30,000 full-ride deposited in a bank account or college savings CD earning 3% (higher than the current rate) would be worth approximately $15,000 worth of tuition in 18 years. To put it another way, if four-years of tuition and fees at a public university costs $30,000 today, it would cost just over $101,000 in 18 years at a 7% annual rate of increase.

    That means that enough money for a full ride to a university today deposited into a savings account or CD will not be able to come close to covering the cost of attending college, and that is before the effect of taxes is taken into account. The situation for most families looks grim indeed.

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    What Is A 529 Plan?

    college-education Fortunately, there is an alternative that can help make the equation look a little bit more promising. A 529 plan is a type of tax-advantaged account that offers a way to invest money for college without having to pay taxes on the interest or capital gains while the money is inside the account. Unlike retirement accounts like the traditional IRA or 401(k) plans, the money can also be withdrawn tax-free when used to pay for qualifying college expenses.

    Although 529 plans were created by Congress at the Federal level, they are actually administered by the states. All 50 states offer a 529 plan. You do not have to use your state’s 529 plan, although you can deduct 529 plan contributions in some states from your state income taxes if you participate in your home state’s 529 plan.

    529 plans are not tied to the resident’s or to the university’s or college’s location. Anyone can use any state’s 529 plan regardless of where they are a resident. Any state’s 529 plan can be used to pay for schooling at a qualified institution in any state. In other words, there is no reason not to use the best 529 plan for your situation.

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    Best 529 Plans

     

    It's hard to determine which state's plan is best. The main issue is that some states offer their residents lucrative tax breaks for using the home state plan. For example, residents of Colorado can deduct 100% of the contribution amount to a 529 plan from their state income taxes. That represents an immediate return of 4.63% for the average family on all contributions.

    However, some states have 529 plans with high fees and expenses than can erase any advantage a tax deduction might offer. Even more confusing, many states offer multiple plans. In Colorado, there is a “direct sold” plan offered through Vanguard which offers the company’s usual low expenses and no frills investing, and there is also an “advisor sold” plan which is sold by financial planners for families that need help in setting up and choosing their investments.

    The best 529 plan research is free and offered by savingforcollege.com. They rate all the 529 plans in every state, and even offer a convenient rating system that is similar to Morningstar’s 5 Star Rating System using 5 Graduation Caps instead of stars, both to maintain the site theme, and to avoid trademark issues.

    Whichever route you go, a 529 plan offers one of the better alternatives to invest for college.