How College Savings Plans Ease the Worry

College students and their parents must dig deeper into their pockets to pay for yet another year of increasing tuition costs.

According to the College Board, the average cost of tuition and fees at a four-year private college rose 5.9%, to $22,218, for the 2006-2007 school year. Though the average cost for a four-year public college was a more manageable $5,836 (a gain of 6.3%), you'd have to tack on another $9,947 if your student hails from outside the home state of the school. And all of this is before the inclusion of room and board, which takes the average price of a public college to $12,796 and a private college to $30,367.

College Savings Plans

Though the figures seem daunting, there are ways to minimize the impact on income through planning. The 529 college savings plans are one of the chief ways to do this.

"In 2006, Congress signaled to everybody that 529 savings plans were going to be the vehicle of choice for secondary education savings going forward," says Bill Raynor, a vice-president at OppenheimerFunds' Wealth Management Group. The federal tax-free status on the plans had been scheduled to sunset on Jan. 1, 2011, but lawmakers decided to make the tax-free provision permanent.

"We had started to see a reduction in people contributing because of the uncertainty around the tax code," Raynor says. "Now, there's been a pickup in participation."

The 529 plans, legally known as "qualified tuition plans," are sponsored by states, state agencies, or educational institutions.

The two types of 529s are prepaid tuition plans and college savings plans. All of the 50 states and the District of Columbia sponsor at least one type of a 529, according to the Securities & Exchange Commission. A group of private colleges and universities sponsor a prepaid tuition plan.

Go to School, or Pay

The 529 college savings plan is generally the most commonly recommended by financial advisers, says Michael Kitces, the director of financial planning at the Pinnacle Advisory Group in Columbia, Md.

Contributions to the account can be made whenever the account holder wishes, earnings on the account are tax-deferred, and if withdrawals are made expressly for college purposes, ultimately they are tax-free. Though the plans have deposit limits, contributions of more than $200,000 can usually be made. College purposes are defined as tuition, room and board, supplies, and equipment. These plans offer several investment options (stock, bond, money-market mutual funds, and age-based portfolios), and the plan invests on behalf of the account holder. The options are not guaranteed by state governments, nor are they federally insured.

The main drawback to these plans is the restrictions on how the funds are used, says Kitces. If they aren't used to pay for education, withdrawals are taxed as ordinary income and a 10% penalty is assessed.