How Uncle Sam wants you to save for college

By U.S. News & World Report

Uncle Sam doesn't usually advise families how to invest their money. But after recent tax-law changes, it's clear that the feds now believe 529 college-savings accounts are the best option for most Americans struggling to keep up with rising educational costs.

Virtually every family with children must now strongly consider putting at least some college savings inside a 529 plan. Here's why:

First, these state-sponsored investment accounts -- offered by nearly all states and the District of Columbia -- allow parents and grandparents to invest large sums (often $300,000 or more per beneficiary).

Moreover, just as with a 401(k), money invested in a 529 is allowed to grow and compound tax-free. That offers parents a huge advantage over traditional brokerage accounts, whose gains, dividends and interest income all are taxed along the way. Finally, 529s are advantageous from a financial-aid standpoint because none of the money held in a 529 is considered the student's asset when calculating aid eligibility.

One key provision that made 529s popular -- the ability to withdraw money from these accounts tax-free for qualified educational expenses -- was to expire in 2010. But the Pension Protection Act of 2006 made withdrawals from 529s permanently tax-free when used for qualified purposes, such as tuition, fees, and room and board.

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"Now we can say with confidence that 529 plans are definitely the first place parents should look" when deciding where to put their college money, says Rita Johnson, a financial adviser with the Millstone Evans Group of Raymond James & Associates in Boulder, Colo.

Congress ignores the Coverdells

Of course, 529s aren't the only savings accounts that allow parents to shelter their investments from taxes and to withdraw money for college without paying taxes on it. So-called Coverdell education-savings accounts do that, and, unlike funds in 529s, Coverdell money can also be used to pay for primary- and secondary-school costs.

But Congress conspicuously did not extend some attractive features of Coverdells, which are due to sunset at the end of 2010. The benefits include the ability to contribute up to $2,000 a year into these tax-advantaged accounts. After 2010, maximum annual contributions into a Coverdell will fall to only $500. What's more, K-12 expenses will no longer qualify.

As a result, parents now investing their kids' money in Coverdells "need to give strong consideration to the enhancements of 529s," says Elaine Sullivan, the director of education savings for Putnam Investments.

Though the federal government could extend these beneficial Coverdell provisions, there are no guarantees.

But Bruce Harrington, the director of 529 plans for the investment-management firm MFS, still advocates "putting the first $2,000 into a Coverdell and then putting your remaining savings into a 529." That's because under current law, money invested in Coverdells can still be used for K-12 expenses. And unlike 529 assets, Coverdell money is permitted to purchase equipment such as computers for kids between kindergarten and 12th grade. "Why not buy Johnny a laptop with tax-free dollars?" asks Harrington.

If the K-12 option does sunset in 2010 as scheduled, don't worry. The Internal Revenue Service would still allow Coverdell owners, as it now does, to roll over their accounts, free of taxes, into a 529, Harrington notes. Meanwhile, families are not permitted to roll money over in the other direction, from a 529 to a Coverdell. So why not preserve your options by first funding a Coverdell and then putting the bulk of your money in a 529?

Forget those uniform gifts

Though the government ignored Coverdells in its most recent tax package, legislation passed in 2006 actually made yet another college savings option -- traditional custodial vehicles such as Uniform Gifts to Minors Act accounts (UGMAs) and Uniform Transfers to Minors Act accounts (UTMAs) -- much worse.

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