by Archie M. Richards, Jr., CFP^®
June 20, 2005

Qualified Tuition Programs are the best way to save for college costs. Most people call them "529 plans" because they're described in Section 529 of the IRS Code.

529 plans are authorized by Congress, but they're set up by the individual states. The investments are handled, usually at low costs, by a financial institution chosen by the state. You don't have to be a resident of the state whose plan you use. But using your state's plan may give you state tax savings.

You can't control the investments directly, although you do have many choices. For example, Iowa's 529 plan, run by Vanguard, offers 17 mutual funds, ranging from all bonds to all aggressive stocks. Select the funds you want. You can't switch them more often than once a year.

You may transfer money from the plan of one state to that of another. But again, you can't do this more often than once a year.

Contributions to 529 plans are not deductible; you invest after-tax dollars. But the money earned within the plan is not taxed, and neither are the distributions for qualified higher educational expenses.

You can adopt one or more 529 plans no matter how high your income. The maximum size of the account can be very large. Rhode Island offers the highest cap. Once the market value of a Rhode Island plan reaches $315,000, sorry, you have to stop contributing to it. But this would cover just one beneficiary. You may have any number of plans for different beneficiaries, from different states, each having a substantial cap.

You can set up a 529 plan for anyone - not necessarily a relative. You may even set one up for yourself. Say you want to attend a golf school or a cooking school. Accumulate the money in a 529 plan. Your age doesn't matter.

Distributions are not taxable to the beneficiary, providing the money is used for higher education. Qualified institutions include graduate schools, vocational schools, and many foreign schools. Tuitions, fees, books, and supplies qualify. Expenses for special needs also qualify. So does room & board, as long as the student attends school at least half the time.

If a distribution does not comply with the above requirements, the portion attributable to earnings is taxed as ordinary income to the distributee. A 10-percent penalty tax may also apply unless the distribution is due to the beneficiary's death, disability, or the receipt of a scholarship.

The beneficiary of a plan can be changed. Say you set up a plan for your niece, who subsequently decides not to attend college. You should change the beneficiary to a person who's a member of the same family as the niece. Qualified replacement beneficiaries include a son or daughter or descendants thereof of the niece. They include a stepson or stepdaughter, brother or sister, stepbrother or stepsister, father or mother or ancestors thereof, stepfather or stepmother, nephew or niece, uncle or aunt, first cousin, son-in-law, daughter-in-law, father-in-law, mother-in-law, or sister-in-law. A replacement may also include a spouse of any of the above, providing the spouse is a member of the same household.

If you contribute in one year more than $11,000 to a plan for a beneficiary other than yourself ($22,000 if the contribution is made by your and your spouse), you may be subject to a federal gift tax. Exactly how this would occur is too complicated to explain here. But you may contribute up to $55,000 in a single year ($110,000 with your spouse) providing you advise the IRS that the gift is to be allocated over five years. If you make no other gifts to that person for the five years, a gift tax is avoided.

Plans vary from state to state. Make sure that the provisions you want are permitted by the state you choose.

College costs are an enormous burden these days. To accumulate substantial amounts for this purpose, there's no better way to do it than with 529 plans.