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The costs of higher education continue to rise. One estimate forecasts a price tag topping $300,000 for four years at an in-state public school by 2031. And that means most families will need to carefully consider how they can best manage this expense.

A great option is to sign up with a savings vehicle that offers a tax break as you sock away money. A qualified tuition plan — also known as a Section 529 college savings plan — is an example. Assets in 529 plans hit $166 billion in 2012, according to investment research firm Morningstar Fund Research.

How the Plan Works

529 plans are operated by many states, as well as some educational institutions. Although every 529 plan differs slightly, most can be categorized as either a savings plan or a prepaid tuition plan. Prepaid plans generally allow you to pay for tuition (and in some cases, room and board) at today’s rates for a student who will attend college in the future. A cautionary note: Many of these plans are sponsored by state governments, and require either the owner or beneficiary to be a state resident.

A college savings plan, in contrast to a prepaid plan, generally allows you — the account holder — to open an account for a student (the “beneficiary”) and then choose among several investment options. These might include stock or bond funds, or age-based portfolios that automatically shift to more conservative investments as the beneficiary gets closer to college age.

Why 529 Plans are Popular

Earnings on the funds in a 529 plan aren’t subject to federal income tax. Earnings also escape state income tax in many — although not all — states.

Moreover, distributions from a 529 plan typically can be made without penalties or federal taxes, as long as the funds are used for qualified higher education expenses at eligible institutions. This typically includes tuition, room and board, books and computer technology.

Contributions to 529 plans are limited only to the extent that they shouldn’t exceed the beneficiary’s qualified education expenses. (Withdrawals can’t exceed actual education expenses, either.) In addition, contributions to a particular beneficiary may trigger gift taxes if the amount, plus other gifts, exceeds the gift tax threshold.

Anyone can establish a 529 plan or be named a plan beneficiary. So, while many plans are set up by parents for their children, you can open one for a friend or other relative — even yourself. The government doesn’t limit the number of plans you can open.

The donor(s) to a 529 plan, which in many cases are the parents, retain control of the funds until they’re withdrawn.

But, what if your child makes it through college and by a stroke of good fortune has money remaining in his or her 529 plan? You typically can change the beneficiary to another family member without triggering federal income taxes, although there could be gift tax issues.

While many state plans offer tax credits or deductions to win their residents’ 529 business, you generally can invest in plans offered by any state. And, the funds in many plans can be used in any state.

Some plans are offered directly by a state or educational institution; you may even be able to open an account online. Others are sold through financial advisors or brokers, which may impose additional fees or charges.

The Downside

While Sec. 529 plans offer significant benefits, they’re not without some drawbacks. If you withdraw money and don’t use it for qualified educational expenses, for instance, the earnings generally will be subject to taxes as well as a 10% penalty. As with any investment, your account value can fluctuate.

In addition, as with any investment, you’ll be charged some fees to cover managing the account. Research the fees to ensure they’re reasonable.

The Bottom Line

Despite these shortcomings, many 529 plans offer a worthwhile means of saving for college — which remains one of the best investments anyone can make. For additional information on our estate & trust services, please contact Jordon Rosen, CPA, AEP, at 302.225.0600 or click here to email Jordon.  In a brief consultation he can assess your situation and determine the best way to proceed.