Saving for College Tax-Free

Feb. 11, 2007 — -- Wayne and Nori Dempsey of Torrance, Calif., have two children under the age of three and another on the way. They should be thinking about things like kindergarten and playing in the park, but their minds are much further down the road -- by about 16 years, in fact.

They are already thinking about college.

They have big dreams of sending all three kids to college, but they know that will come with a hefty price tag.

"We predict that maybe we need about $250,000 per child," says Wayne.

It could cost even more. At the rate costs have increased over the last 20 years, the cost of college for a young child today could be upwards of $300,000 -- which has parents like the Dempseys wondering how they'll be able to afford it.

"It's daunting. It's extremely daunting," says Wayne. "It's very difficult to grasp your mind around the fact that it is so much money."

To help reach their goal, Wayne and Nori opened up 529 college savings accounts for both of their children; two-year-old Sean and one-year-old Holly. Among different vehicles that parents can use to save money, the 529 plan is a fairly new option with growing appeal.

Named for a section of the Internal Revenue Service's tax code, 49 states and the District of Columbia have 529 plans, and many offer tax breaks to the people who invest in them. 529s let you put away up to $12,000 per year, per child. The money can be invested in the stock market and grow tax free.

Choose Your Plan Carefully

The plans can seem confusing at first. You can choose a plan from whatever state you wish, no matter where you live. And it doesn't matter where your child decides to go to college.

The funds are also transferable from child to child, and the account owner can switch the beneficiary once every 12 months. Family members can open accounts for nieces and nephews; grandparents can open accounts for their grandchildren.

If you do need to take money out of the account, there's a penalty usually of 10 percent, and you will have to pay taxes on the money you take out, making the transfer option more appealing.

Joseph Hurley is the founder and CEO of Savingforcollege.com, a comprehensive Web site that compiles and analyzes information on 529 plans. Hurley says other than the risk of investing in the market, there really isn't a down side if you have the money.

"It is extremely useful because it is a vehicle that allows you to set aside dollars for college, get that money invested," says Hurley. "Hopefully, it will grow over time and you don't have to pay income taxes, and you might even get a state deduction on your own state's income tax return."

Best-Kept Savings Secret

In fact, 529 plans seem to be the best kept secret of college savings. In a new ABC News poll, two-thirds of parents had never heard of them. And of those who had, only 8 percent are saving for college using 529s.

"There are lots of choices, and sometimes I think there are way too many choices," says financial planner Doug Taylor of Taylor Wealth Management. "It makes it confusing to a lot of people, and therefore some people don't do anything because they're overwhelmed by what to do and afraid of making a wrong choice."

Tuition, fees, room and board for public and private institutions have been rising steadily for decades. For the 2006-2007 school year, the average cost of a public school was $12,796; for private school, a whopping $30,367. Financial planners agree the most important thing for parents is to start saving as soon as possible.

The Dempseys chose Utah's 529 plan because they liked the mutual funds it offered. The plans offer the most advantages to people with a lot of money: They get the most tax savings. But many states are trying to bring in lower-income investors as well.

Wayne and Nori say the 529 plans give them peace of mind as they prepare for their children's future.

"If you have [the money] in the 529 plan, then it's away and out of the way," Wayne says. "It's kind of a mini-retirement plan to pay for your own kids' education."

While $300,000 might not be so mini, it is a plan that could work.