by Lori Kaye

Created on: August 07, 2009   Last Updated: December 20, 2009

The 529 plan is one of the best ways to save for college. There are two types of plans: the prepaid tuition plan and the college savings plan. Both of these are tax free as long as the proceeds are used for education expenses.

There are benefits to each plan. The prepaid tuition plan allows you to lock in tuition at the current rate. The college savings plan is more flexible, and can have a higher rate of return.

The 529 plan is administered by the state. Most states offer the savings plan, but only a few have the prepaid plan. Also, a number of private colleges offer their own tuition plan, called the Independent 529 Plan.

Prepaid Tuition Plan

The prepaid tuition plan allows you to purchase college credits at today's rates. For instance, if you purchase 12 credits today, your child can redeem them for 12 credit hours years in the future.

There are several benefits to choosing a prepaid tuition plan. First is simply the peace of mind you get from locking in today's tuition rates. Second, it is a very simple plan. Third, there tends to be a better rate of return than most certificates of deposit or bank savings accounts. And fourth, your principle is secure.

The prepaid plan has a few disadvantages as well. The program is administered by your state, so the credits you purchase are meant to be used in the state college system. If your child attends a different college, then your state only pays its average tuition and you pay the difference. Also, if you've moved out of state, and your child still attends the state college, you may have to pay the additional non-resident tuition.

College Savings Plan

The college savings plan doesn't lock in tuition rates, but is an actual savings investment account. Your investment is subject to the market, but in exchange for the added risk, you may realize greater returns.

The money in the account is controlled by the owner. This allows you to choose the level of risk you are comfortable with. Typically, the younger the child, the more aggressive the investments.

Tax Status

Investments and earnings in a 529 account are tax exempt at the Federal level, and in most states.

Withdrawals are also exempt if they are used to pay for qualified education expenses. These include tuition, fees, books, supplies and equipment, and room and board. If they are used for any other purpose, a 10% penalty is imposed on that amount, and it is subject to normal income taxes.

Contributions are often deductible on state income tax. These benefits are usually limited to the state's own plan. For instance, if your grandchild has a plan in Florida, but you live in California, you might not be able to claim a deduction for contributions to that account. You need to check with your state to see what laws apply.

There are many benefits to including a 529 account as one part of your college education savings plan. With a little research, you can learn which programs your state offers and what tax benefits apply.

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