529 Plan: Back in 2001, Congress passed a bill that gave all 529 plans tax relief. 529s do not create federal capital gains, dividend, or interest taxes. This tax break gives them a big advantage over other college savings strategies. All 50 states offer 529 plans, although, each one is unique. For financial aid purposes, parents should open the account in their name and make the child or children beneficiary. You are allowed to change the beneficiary at any time to pay for qualified college expenses. You are allowed to put up to the $13,000 gift tax limit per year ($26,000 for a married couple) per beneficiary. Or, you have the option of front loading up to 5 years of contributions for a total of $65,000 ($130,000 for married couples). Although, no other gifts can be given for the next 4 years. Each plan has maximum amounts that can be accumulated in each individual 529 account. So, if you have two kids you may need to open two accounts instead of just having one 529 account and changing the beneficiary.
Contributions go into an investment account offered by financial institutions like Vanguard, American Funds, etc. They offer age-based choices that get more conservative as the beneficiary gets closer to college or you can pick the investments on your own. There are limits and rules including allowing just one investment change per year. The Vanguard 529 plan offers low cost funds and a variety of fund choices.
Depending on the state you live in, you may be able to deduct contributions from your state income tax return as long as you contribute to the state 529 plan.
Prepaid College Plans: Prepaid tuition plans are accounts that allow you to pay for your child's future college tuition at today's prices. If you have enough money now, you could pay for a complete four-year degree that your child won't use for another 18 years. Or, you can break payments down into more manageable monthly payments.
Some plans allow you to purchase individual tuition credits. Others let you buy a semester's or year's worth of tuition. Prepaid tuition plans are actually a variation on 529 plans, but with lower risk. What you lose is the potential to earn more by investing that money in a college investment plan described above. The money you put in is guaranteed by the state administering the plan. Most prepaid plans can only be redeemed at public colleges and universities in that state. In many cases, you or the student beneficiary of the account must also live in that state.
If the child goes to a private or out-of-state university most prepaid plans will pay the average cost of a public university in the year the child is attending college. In most cases, this amount will not cover all costs and the gap will have to be covered by other funds. About 250 private schools have come together to form their own prepaid tuition plan called the Independent 529 Plan, which began in 2003. The tuition plan consortium includes Princeton, Stanford, MIT, Notre Dame, and many other private universities.
If you purchase this plan, your child can use the tuition credits at any participating school. If your child decides not to go to one of these schools, the plan will give you a full refund with interest. The minimal amount of interest isn't taxed as long as you spend the money on higher education.
Coverdell: These have an annual contribution limit of $2,000. Also, the tax break for using Coverdell funds to pay for K-12 tuition is scheduled to expire at the end of 2012.
Taxable Accounts: The choices here are quite varied and include joint accounts, accounts for minors, and savings accounts. The biggest difference is the tax treatment. Interest, dividends, and capital gains are all taxed either at the parents tax rate or the child's. You also have to worry about disqualifying the child from financial aid depending on who's account it is and how much is in it. Accounts for minor such as UTMA or UGMA by law have to be handed over to the minor on the account at age 18 or 21 depending on the state. This means the money could be used for things other than college.
