How 529 Plans Work

College is expensive, and it keeps getting more expensive. It's tough to predict what college is going to cost in 10 or 15 years, because the cost can't keep spiraling upward endlessly. But the best way to get an idea of what college costs will look like in the future is to look at the real numbers. What does college cost today, and how much have those costs risen in the last ten years?

Based on U.S. Department of Education data, the Institute of Education Sciences reported that costs for undergraduate tuition, room and board at a public college or university during the 2010–11 academic year totaled $13,600. Of course, those costs skyrocket if you go private: Prepare to spend about $36,300 at private not-for-profit institutions, and $23,500 at private for-profit institutions. These costs have only risen in the last few years: The Institute of Education Sciences also reports that "between 2000–01 and 2010–11, prices for undergraduate tuition, room, and board at public institutions rose 42 percent, and prices at private not-for-profit institutions rose 31 percent, after adjustment for inflation. The inflation-adjusted price for undergraduate tuition, room, and board at private for-profit institutions was 5 percent higher in 2010–11 than in 2000–01 [source: Institute of Education Sciences]."

In other words, saving money now for college is not a bad idea, and a 529 plan might be a good way to do it.

The 529 Plan (named for Section 529 of the IRS tax code) is a savings plan for college education. There are two types of 529 plan:

Either option lets you earn interest on your investment. Pre-paid tuition plans have some serious drawbacks, mainly because they're more restrictive with who can participate and how the money can be used. For that reason, we're going to focus this article on the more flexible 529 investment plans.

A 529 plan is a state-sponsored investment program. That is, the state sets up the plan with an asset management company of its choice, and you open a 529 account with that asset management company according to the state's predetermined plan features. You're the owner of the account, and the child for whom the account is set up is the beneficiary. You won't deal directly with the state, but rather with the asset management/investment company. Like any other investment, a 529 is subject to market risk – the state doesn't guarantee your money.

How do 529 plans vary from state to state? Find out next.

Because each state can control some of the features of its own plan, there are variations from state to state. Most plans follow the same general scheme (and federal requirements), but make sure you compare plans among states other than your own. Also, some states offer multiple plans which can differ from each other, so make sure to compare those too.

There are no residency requirements on 529 plans. You can invest in any state's plan, whether you live there or not, and you can draw funds from the plan to pay for college in any state, whether it's in your home state, the plan's home state, or some other state. Some states do require non-residents to work through financial advisors or brokers to buy into their plans, and that can add some costs to the plan.

CollegeSavings.org offers a comprehensive comparison tool that lets you see which plans are available in which state, and compare their features.

In the next section, we'll look at some of the things that make the 529 plan so attractive.

All of a 529 account's earnings are exempt from federal taxes when they're withdrawn if they are used for qualified education expenses. This means that, unlike the taxes you have to pay on earnings from regular stock investments, you won't pay any taxes on 529 account earnings unless you end up using the money for something other than higher education. Earnings are currently tax-deferred in most states, as well.

A break on the earnings tax isn't the only tax advantage, either. Although your contributions aren't pre-tax (you pay state and federal tax on the money you put into the account), there are some states that let you deduct a portion of your contributions from your state taxes.

One of the nice things about a 529 plan is that qualified education expenses are very broadly defined (much more liberally than with a prepaid tuition plan). Eligible expenses include tuition, room and board, fees, books and even computers. If you need it to study, you can probably use the 529 plan to purchase it.

Unlike custodial accounts or Education Savings Accounts (ESAs, formerly Education IRAs), the beneficiary doesn't gain control of the money at a specific age (usually 18 or 21 for those types of accounts). The account owner always has control of the money. You don't have to worry that your child will grow up and spend the money frivolously.

There are no restrictions on who can open an account for whom. You can open an account for your child, a friend's child, a relative, the paper boy, or even yourself. 529 plans have no age restrictions either, so an adult could open one to pay for some classes next year.

If it turns out that the beneficiary won't be using the money in the 529, there's a lot of flexibility in how you can ultimately use the money. You can change the beneficiary, or you can roll the funds over into a different qualified investment product. There may be additional fees, depending on what you choose, and some account changes are limited to once per year.

You can withdraw the money for non-education purposes if absolutely necessary, but you'll have to pay the tax on the earnings, plus a 10 percent federal tax penalty.

As we mentioned on the last page, custodial accounts (also known as Education Savings Accounts or ESAs) are a bit more rigidly structured than most 529 accounts. Here's one major example: Did you know you can't contribute to an ESA if you make more than $95,000 per year ($190,000 for married couples, as of 2012 [source: SavingForCollege.com]? Unlike ESAs, your income doesn't affect your eligibility to open a 529 account. In addition, most states don't limit contributions either, which is crucial for those who want to pass money to their children or grandchildren for school.

Contributions to 529 plans also qualify for the $14,000 ($28,000 for married couples in 2013) annual gift tax exclusion [source: Securities and Exchange Commission]. You can also contribute up to five years of gifts during the first year. This is a great benefit in situations where inheritance money enters the picture.

The contribution limits (the maximum you can put into the account) are very generous in most states, typically above $200,000. At the other end of the spectrum, you can contribute as little as $25 to $50 per month.

Most states' 529 plans are managed by investment companies such as TIAA-CREF, Vanguard and Fidelity. The number and types of investment options vary by state, and once you select your option you can't change it. You can, however, roll your money over into another state's plan if you're not happy with your chosen investment option. There is no penalty to roll the money over into another state's plan, and you can do it once every 12 months.

Many plans are also offering investment choices that are age-based. This means that if you're starting early, perhaps when your child is age one to three, the investments can begin aggressively in stocks then gradually shift to bonds and money market accounts as your child gets closer to college age. Some state plans offer several levels of options for aggressive, moderate and conservative investments.

If you can't reach the risk level you want in one plan, you can always open a second 529 account in the same or another state. You can have as many accounts as you want and can also contribute to both a 529 plan and an ESA. That way, you can diversify your investments in the event that the plan doesn't offer the investment mix you would like.

Money deposited into and drawn from a 529 does have an effect on financial aid eligibility. However, that impact has been greatly reduced by changes to the law.

If the 529 account is owned by the parents, the amount in the account will count as a parental asset. Such assets count at a maximum of 5.64 percent toward the family's eligibility for aid [source: SavingForCollege.com]. Since 2010, student-owned 529s are also calculated as assets at the 5.64 percent rate as long as the student files as a dependent on the Free Application for Federal Student Aid (FAFSA) and includes parent assets and income. If the student doesn't meet these conditions, the 529 assets will be calculated at 20 percent [source SavingForCollege.com].

When money is drawn from a 529 to pay expenses, the amount that the investment earned would be considered income (even though it's untaxed). However, that amount of income is not counted against the student when determining next year's financial aid eligibility.

529 plans aren't completely perfect investment vehicles – they do have some drawbacks. For one thing, you don't control the specific investments being made with your money. Like any other investment plan, the brokerage or investment firm that handles that particular plan controls the specific mix of investments the money will be used for. For example, you can't buy, trade or sell individual stocks with your 529 money. We'll talk in more detail about your level of control over the 529 investment in the next section.

There are other disadvantages to having a 529 account as well. As we said before, if you have to withdraw the money for some reason other than to pay for qualified higher education, then you pay tax on the earnings and a 10 percent penalty. There are some limits on what you can deposit into the account as well: You can only make cash contributions to the account; stocks can't be rolled over into it.

If you have multiple children or grandchildren, keep in mind that each beneficiary must have his or her own account. Siblings or cousins can't share an account (although, as we mentioned, you can roll an account over to a different beneficiary).

Remember that a money management company – not you or the state -- actually manages your investments. The state works with those companies to set up your selection of investment options. Your plan's investment manager determines where and how you can invest your 529 account funds. Many states are expanding their investment choices, making it easier for most people to find a plan that suits both their goals and their acceptable risk levels.

In addition to mutual funds, most state plans are also beginning to offer several age-based portfolios of mutual funds that include conservative, moderate, and aggressive asset allocations. These types of investment choices start out in stocks when your child is very young and shift gradually to bonds and money-market funds as your child gets closer to college-age. The idea behind the age-based portfolios is to be aggressive when you have more time, but to keep your investment safer as it gets closer to the time that you need to cash out. The perk behind this scheme is that you don't have to remember to shift the investments yourself. You can buy it and then forget about it. In addition to the age-based portfolios, you may have the option of 100-percent stock and fixed-income funds that can be used alongside an age-based portfolio in order to fine-tune the overall allocations to suit your needs.

If you decide later on that you're not happy with the way your account is growing, you have the option of rolling your money over into another state's 529 plan without penalty. Keep in mind that if you're getting a state tax break by using your own state's plan then you'll lose that by moving to another state's plan. You can always keep the account in your state and open a second account in another state. There is no limit to the number of accounts you can have -- even for the same child.

Choosing the right 529 plan is no harder than choosing anything else in the financial world. If you do your research, you can find the right plan for your family. Here are few guidelines to get you started:

Read on for some other educational investment vehicles that you can use in tandem with your 529 plan.

529 plans aren't the only options for college savings. Custodial accounts and education IRAs are other ways you can set aside money for college expenses.

Money that goes into a custodial account is an irrevocable gift belonging to the child. The money out into the account lowers the family's total taxable income as long as the child's total income remains fairly low ($950 in 2012) and that income comes solely from interest. However, custodial accounts that earn significant amounts of money for the child (more than $1,900 in 2012) will be subject to taxation, which may eliminate their advantages. Other drawbacks include: the money has to be used for the child's benefit, not for your own or your family's (how much of a disadvantage this is depends on how likely it is that your own children will sue you over it); the child can spend the money on anything once he or she reaches either 18 or 21 depending on your state's age requirement; money in the child's name counts against the child's eligibility for financial aid. Money in a custodial account can be converted to a 529 plan, but the child still technically controls it [source: FINRA].

Congress improved Coverdell Education Savings Accounts significantly when Congress increased the annual contribution limit from $500 to $2,000 in 2002. Like 529 plans, ESA earnings are tax-free when used for education expenses, and they're considered the parents' asset so they don't adversely affect financial aid eligibility. They do have some advantages over 529 plans, including more control over your investments and the ability to use the money for private elementary or secondary school expenses.

People with higher incomes can't contribute to an ESA. For single tax payers, the eligibility phases out for incomes between $95,000 and $110,000. For married taxpayers filing jointly, eligibility phases out between $190,000 and $220,000. Another disadvantage is that the funds have to be used for education by the time the beneficiary turns 30. Like the 529, there is a 10-percent penalty if the money is used for anything other than education expenses [source: SavingForCollege].

For lots more information on saving money for college, explore the links on the next page.