529 college savings programs, which all states sponsor, offer you a tax-free way to save for future college costs. These 529 qualified tuition programs are named after the section of the tax code that governs them.

There are two main types of 529 programs -- prepaid tuition plans and college savings plans -- and each state plan has its own terms and features. You can invest in one or both types of programs. And you can set up accounts in more than one state for the same beneficiary, as long as you don’t contribute in total more than what is considered needed for future higher education expenses.
 
The specifics of each program vary greatly. So before you sign on, consider your other college funding options, get the details about the investments, fees, restrictions, and tax benefits, and consult a tax advisor if necessary.

The federal tax benefits

When you make qualified withdrawals from a 529 college savings program your earnings are free from federal income tax. (Prior to 2002, qualified withdrawals of earnings were taxable at a student’s income tax rate.)

Along with the rest of the Tax Act of 2001, the provision that made 529 earnings free from federal tax is set to expire at the end of 2010. Therefore, if Congress doesn’t extend the tax break or pass new legislation, earnings will revert to being taxed at the student’s federal income tax rate.

The state tax benefits

State rules governing 529 programs vary. Most states allow residents to exempt earnings from state income tax. And some allow state residents to deduct the full or a partial amount of their contribution from state income taxes.

Some college savings programs are open to residents of all states. Importantly, however, out-of-state participants may not be granted the state tax breaks. For example, you will not qualify for a state tax deduction if you contribute to an out-of-state college savings plan. And some states tax earnings withdrawn from out-of-state plans, generally at the student’s state tax rate.

Because state tax breaks are restricted to state residents, the FINRA, the self-regulatory organization for the U.S. securities industry, recommends that investors consider their home state 529 college savings plan before considering other plans.

The FINRA further recommends that investors weigh their home state plan’s fees, expenses, and investment performance against its state tax benefits. For instance, if a plan has high fees and poor performance, those disadvantages may outweigh the state tax breaks. Conversely, the state tax benefits may outweigh those disadvantages.

For more information

• A Guide to Understanding 529 Plans, The College Savings Plan Network, www.collegesavings.org
• College Savings Plans – School yourself before you invest Investor Alert, FINRA Investor Information, www.finra.org
  

Article is for educational purposes only and is not intended to provide specific tax or legal advice. For answers to tax questions, please see your tax professional. For legal questions, consult an attorney.

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