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How to Save for College Without 529s

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By Jeff Brown

If you know anyone with a child in college or one that will be soon, you know this is hand-wringing time, as families sweat admissions and financial aid awards.

For families with college costs in the future, it's a reminder of the need to put aside as much as possible, else your child will someday leave school with a mountain of debt. Assuming you can afford to put money aside, what's the best type of account to use?

Section 529 plans. Named for the federal law that makes them possible, these allow parents, grandparents - or anyone else, for that matter - to put aside large sums. There's no tax deduction on contributions, but all withdrawals are exempt from federal income tax if used for approved purposes like tuition.

States set the maximum-contribution limits, but most allow a total of $200,000 to $300,000, sometimes more. Though 529s are set up by the states, most allow non-residents to invest, even if the student is not a resident either. In many cases, however, residents get a state tax break on contributions, investment gains or both.

Among the most popular options are age-based accounts that emphasize stocks for young children and automatically shift to a safer mix of stocks and bonds as the college years approach. A 529 account is an asset of the person who sets it up, typically a parent or grandparent, so it does less damage to the student's financial aid eligibility than most other types of college savings.

Unfortunately, shopping for 529s is tricky, and many families overlook the fact that they can lose money. There are sevreal options for college savers, though:

Education Savings Account. Often called Coverdell Accounts, ESAs offer tax-exempt savings and have many other similarities to 529s. However, ESAs can be used for qualified secondary-school expenses in addition to college. Unfortunately, contributions are limited to $2,000 per year per student, no matter how many accounts are set up.

As with 529s, federal income tax plus a 10% penalty are charged on non-qualified withdrawals. While 529s limit investments to those in official state plans, an ESA can hold just about any type of asset, much like an IRA.

UGMA or UTMA. These stand for the Uniform Gifts to Minors Act and the Uniform Transfers to Minors Act, nearly identical laws that allow adults to set up custodial accounts for the benefit of children. Investment choices are basically unlimited, and there's no limit on contributions. Contributions are not tax deductible, but gains may or may not be tax-free depending, for the most part, on the child's age.

For many people, the biggest drawback is that the child gets complete control of the account after reaching 18 or 21, depending on the state. Before then, the accounts must be managed and spent solely for the child's benefit. Because the assets are the child's, they can substantially reduce the child's eligibility for financial aid.

Taxable accounts. College savings can always be put into standard accounts. While there are no tax benefits, this is the most flexible option. There's no limit on contributions, how the money can be invested or spent, or when it can be withdrawn. If the child doesn't go to college or doesn't need all the money, the account can be used for any other purpose, such as the parents' retirement. Because the assets are the account holder's rather than the child's, a parent's taxable account is less damaging to financial aid awards than a UGMA or UTMA. A taxable account in a grandparent's name would have no effect on the family's aid eligibility.

Bottom line: If you are certain college is in your child's future and want to invest substantial sums, a 529 plan is probably the best option. That's especially so if the child is young, leaving many years for investment growth, which would make tax exemption on withdrawals very valuable.

Morningstar Inc. (Stock Quote: MORN) has a useful list of the best 529s mostly those using low-fee mutual funds in an age-based program.

Beware of fees, which can be higher for 529s sold through brokers and financial advisers. The "direct-sold" plans, available through mutual fund companies designated by each state's program, generally have lower fees. Vanguard Group, which offers some of the best-rated 529s, has an easy-to-read chart summarizing features of different types of college-savings accounts.

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