So-called 529 plans, named after Section 529 of the Internal Revenue Code, have enjoyed a boom since passage of the 2001 tax law.  Prior law offered tax-deferred investment buildup inside these plans;  the 2001 act also allowed tax-free withdrawals for higher education expenses.

Other portions of the 2001 law, though, may have discouraged potential investors.  For example, withdrawals were due to become taxable again, at the student’s rate, after 2010.

Now, the new provision in the Pension  Protection Act of 2006 removes that uncertainty.  Tax-free withdrawals from 529 plans for higher education are permanent, or at least as permanent as anything in the tax code.  Unlike other provisions in the tax code, the tax benefits of 529 plans are available to everyone, regardless of income.

Double major

These plans are offered by most states and by various financial firms.  Among 529 plans, there are two main categories.

College savings plans.  These plans really are investment plans for your account will grow (or diminish) depending on how specified investments perform.

Prepaid tuition plans.  Offered by 18 states, these plans guarantee a return that will move in step with tuition increases, regardless of what happens in the stock or bond markets.  Thus, prepaid tuition plans seem like a good deal, especially with college costs escalating rapidly.

Prepaid tuition plans look even better now, after a change in federal law earlier this year, allowing them to be considered as parental assets for purposes of determining financial aid, the same as 529 college savings plans.

Learning the limits

However, there are disadvantages.  In many cases, prepaid tuition plans are open only to residents of the state offering the plan.

As the name suggests, money accumulated in 529 prepaid tuition plans generally can be spent only on tuition  (and mandatory fees and/or room and board).  They usually don’t cover other discretionary costs.

You’ll probably pay a premium for the upside-but-no-downside guarantee.  Investing, say $20,000 might buy you $16,000 worth of current tuition.  After some time, your $20,000 investment could buy $25,000 or $30,000 worth of tuition, depending on how tuition costs escalate.  Over a 15-year period, if tuition costs have increased by 8% a year, your annualized return might be around 6.5%, because of the upfront premium you paid. 

What’s more, you also may lack educational choices if you use a prepaid tuition plan.  With many 529 prepaid tuition plans, money can be spent only at the sponsoring state’s public universities.  In some others, money can be spent at private universities – but still within the sponsoring state.  If your child decides to go to a college that’s not in a covered state, you usually can get your money back, but with a scant return on your investment, or no return at all.

Going Independent

One prepaid tuition plan, the Independent 529 Plan, covers more than 250 private colleges around the country, including some of the nation’s top institutions.  TIAA-CREF administers this plan and manages its investments. 

Money you place into this plan can be used at any of the participating schools;  there’s no need to make a selection in advance.  In addition,  all of the colleges participating in the Independent 529 Plan are required to discount their tuition by at least 0.5% per year.

Suppose, for example, you make a contribution to the Independent 529 plan for son William when he is eight years old.  Ten years later, William enrolls in a private university that offers a 1% tuition discount through this plan.

If so, William will be entitled to a 10% tuition discount (1% times 10 years) when he applies his Independent 529 Plan certificate to tuition at that university.  This discount effectively  increases your ultimate return, so that your initial outlay will more than keep up with tuition increases that occur at the college that’s eventually selected.

Combination course

Considering all the possibilities, one strategy to consider is combining 529 plans.  You might put enough money into a prepaid  tuition plan (a state plan or one offered by a financial institution) to lock in full payment for some future tuition.  In addition, you can contribute to a 529 savings plan for your youngster.  Under current law, tax-free withdrawals  from a 529 savings plan can be used not only for tuition but also to pay for room and board, books, etc.

Educated choices

When choosing a 529 college savings plan, look for those that offer good investment options, managed by first-rate professionals, because your ultimate payoff will depend on the performance of those accounts.  Pay attention to the cost side, too.  Over the long-term, lower expenses can make a significant difference in your total return.   Even within the same state, costs for different 529 plans can vary widely.

State of the Art

For prepaid tuition or college savings plans, many investors favor their own state’s 529 plans because of state tax deductions.  Those features should be considered but you shouldn’t automatically choose your own state’s plans.  Find out how much you’ll actually save in taxes and see if those savings are worth what you might give up in other features. 

Say you pay state income tax of 4%, net of a federal tax deduction, and you invest $50,000 in a 529 plan.  Going in-state would save you $2,000 (4% of $50,000).  You have to decide whether another state’s plan is inexpensive and flexible enough to be worth giving up that $2,000 in tax savings.

Un-covered

Although 529 plans received permanent tax breaks, the same treatment was not extended to Coverdell Education Savings Accounts (ESAs).  Thus, Coverdell ESAs are still in jeopardy of regaining their prior tax treatment after 2010.

If this happens, Coverdell ESAs no longer will offer funding for K-12 expenditures and Coverdell ESA withdrawals may put some other education-related tax breaks off-limits for that year.   Nevertheless, it’s not necessary to give up on Coverdell ESAs because tax-free transfers to 529 plans are permitted.