Saving for college: Everything you need to know about 529s

Terrified of what college might cost by the time your child turns 18?

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One of the best places to start is with a 529 college savings plan. While there are a few other options to earmark savings for education, such as Coverdell Education Savings Accounts, "529s are almost always the best option for saving for college," says Natalie Taylor, a CFP® with LearnVest Planning Services. "They have both flexibility and tax benefits that often make them more effective and wallet-friendly than other college savings vehicles."

But not every 529 is created equal — each state sponsors their own version (or two), and allows both local residents and non-residents to invest. That's why we consulted CFP® Taylor, as well as Joe Hurley, founder of savingforcollege.com, a website that specializes in 529 plans, to help us figure out how a 529 works, what you should know about using this vehicle, and how to find the right plan for you.

529 plans, named for the section of the Internal Revenue Code that created them, are state-sponsored, tax-advantaged savings accounts that can be used to pay for qualified college costs — meaning tuition, fees, room and board, textbooks and even necessary technology. The funds can be used at any accredited school, public or private, anywhere in the country and occasionally overseas. Similar to a Roth IRA, money you contribute to a 529 will already have been subject to federal income tax, but once inside an account, the funds grow tax-deferred.

Most of the money in 529s today is invested in age-based portfolios, which are similar to target-date funds used for retirement savings. As a child nears college age, the investment mix gets more and more conservative. "It's the 'set it and forget it' approach, where allocations are automatically adjusted as your child gets older," explains Hurley. When the money is used for the approved expenses listed above, both your contributions and the gains come out tax-free.

"If you're looking to put away fairly significant dollars for college, 529s are going to be your best bet," says Hurley. States have set different lifetime limits on the amount of money you can contribute — most caps are north of $200,000 — and there are no income limits, meaning you can contribute no matter how much you earn. (Remember that in 2014, the full tax benefits of a Roth IRA are limited to individuals earning under $114,000 gross a year, or couples earning under $181,000, and that contributions are capped at $5,500 annually.)

A 529 account is typically "owned" by a parent, with a minor child named as the beneficiary. But anyone can start a 529 in a child's name, whether it's a grandparent, friend, or relative. Many 529s also accept third-party contributions, so grandparents and friends can contribute to an account you open on your child's behalf. There's also no limit to the number of 529 plans you can open. If you have several children, you can create a separate 529 for each child — each account can only have one beneficiary at a a time, so while you could just switch the beneficiary to your second child after your first finishes with the account, you'll probably want to open separate accounts for kids who are close in age and would attend college at the same time. You can even have multiple accounts open across multiple states.

If your child doesn't need all of the money for college, you can save the cash for graduate school expenses or change the beneficiary to another family member, whether it's a younger child, stepchild, niece or nephew, or even yourself if you're planning to go back to school. If there simply aren't any more education costs to finance, you can withdraw the money early for non-education expenses — although the typical cost of that withdrawal is taxes on the gains, plus a 10 percent penalty.

"I typically recommend that families aim to save 50 percent to 75 percent of their total college savings in a 529 plan, and the remainder in a more flexible account like a taxable brokerage account to avoid overfunding the 529, depending on the situation," says Taylor. "Most families I work with fund college using a combination of savings, loans and current cash flow — it's not very common to have to pay the penalty to withdraw the funds."

As with most types of savings, the earlier you start putting money away, the better. You can't open an account in your child's name before he or she is born, since 529s require the beneficiary to have a Social Security number. But if you want to start saving early, you can open one and designate yourself both the owner and beneficiary. Once your little one is born, simply change the beneficiary to him or her.

With more than a hundred 529 plans across the country, it's important to shop around, says Taylor. "Each state's 529 is different, and some states have multiple plans," she explains. "You want to do your homework upfront in order to capture the best benefits." Sites like finaid.org, savingforcollege.com, and collegesavings.org allow you to compare and contrast 529s by a variety of factors, including tax benefits, fees and investment options.

"Tax benefits are the first filter that people should run," suggests Taylor. Thirty-one states and the District of Columbia offer residents income-tax deductions for their 529 savings, but the allowable deductions vary significantly. Pennsylvania, for example, allows a married couple filing jointly to deduct $28,000 of contributions to a 529 savings plan in 2014. New York, in contrast, caps the deduction at $10,000 for a married couple, while Maine allows deductions on contributions only up to $250. There are no income limits or restrictions — but be aware that families contributing more than $14,000 a year to a 529 may be subject to gift taxes, depending on their state and situation.

Another major consideration is choosing between a direct-sold plan and a broker-sold plan. "With a direct-sold plan, you open an account directly with the company that administers the state's plan, like Vanguard or TIAA-CREF, through the state's 529 website," explains Taylor. "With a broker-sold plan, you open a 529 through a financial adviser. That may give you the benefit of the advice and expertise of an investment professional, but it also typically means you pay higher expenses."

"Fees are an important consideration when comparing plans," adds Hurley. Even for a direct-sold plan, administrative costs such as program manager fees and account management fees could cost you. "The program manager fee can vary significantly from plan to plan," he says. "The underlying cost of an index fund (also known as the expense ratio), will be similar in any plan that uses that fund, but if the costs of the 529s are different, it may be due to the program manager fees."

And while the expense ratio would be about the same for any plan invested in the same funds, it's a number you want to keep as low as possible. "Look for plans featuring low-fee index funds," Taylor advises. "Index funds typically have expense ratios around 0.2 percent," she explains, "while actively managed funds have ratios more like 1 percent. Those higher expense ratios can eat right into your returns."