Under the new legislation, the 529 plans (named for the Internal Revenue code that created them) are federally tax free.  Beginning in 2002, withdrawals that are used for qualified education expenses are not taxed.  In addition, the new law also allows you to roll over the plan once every 12 months without penalty.
   

"Saving for a college education is an important decision, and it needs careful consideration," says Phyllis R. Scruggs, CFA, CFP.  "The new tax laws have made the 529 plans much more attractive, but they may not be right for you.  Taxes should be one of many factors to consider when judging the merits of investment choices."
   

Scruggs has worked closely with parents and grandparents looking to save for their children's education.  As first vice president of Waddell & Associates, Inc., a provider of investment and financial counsel, Scruggs says she advises her clients to ask themselves a series of questions before deciding to start a 529 plan.

 

What mutual fund family and funds are used within the plan?
Most of the investment plans have funds that are all managed by one mutual fund company.  Although they have different objectives, funds within the same family may have overlapping investments, or utilize only one style, which will reduce diversification.  Scruggs suggests looking carefully at each fund within the family and compare its track record against others within its peer group.

 

Does the plan's asset allocation strategy fit your needs?
Most of the investment plans have a pre-determined allocation of investment dollars which changes to a more conservative allocation as the student nears college age.  This may be less flexible than investing yourself, and it may not fit within your needs.  For example, "If your child is 15 years old, you haven't saved much toward his or her education, and you are willing to take on more risk, you may want to be more aggressive in your investing than the plan would allow," Scruggs says.  Find out if the plan allows you to make changes in how it is invested based on your needs.

 

There can be tax savings in using a home state fund.  Ask what benefits there are to using a plan in the state in which you live.  Along with state tax exemptions upon withdrawal for qualified education expenses, some states offer up front state income tax deductions for contributions.

 

Carol Lee Royer, CFP, CFA, a colleague of Scruggs at Waddell & Associates, adds the following questions:

 

Can you really part with this money?
If you fund a 529, then need the money back for other than qualified education expense, not only will the withdrawal of earnings be taxed in your bracket, but a 10 percent penalty will be imposed.  Before contributing to a 529, make sure your financial house is in order by paying off high interest credit card debt and keeping sufficient cash emergency funds to prevent the possibility of a non-qualified withdrawal. 

 

Should you contribute to an Education/IRA before considering a 529?
While contributions to an EIRA in 2001 are limited to $500/year/child, this will increase to $2,000/year/child in 2002.  Income limits will also be increased for joint tax filers (from $150,000 - $160,000 phaseout range in 2001 to $190,000 to $220,000 in 2002).  Just like a self-directed individual IRA, EIRA's are more flexible since you can invest in whatever investment options your EIRA custodian offers.  In addition, in 2002, tax-free withdrawals covering qualified education expenses can include private school tuition prior to college.  Also keep in mind that in 2002, you can contribute to both an EIRA and a 529 plan (currently, you can contribute to one or the other, not both in one year).
   

Scruggs also advises talking to a financial planner before making any college investment decision.  "With the proper planning, saving for college can be a relatively easy process," she says.  "If you ask the right questions, you can make an informed decision and not allow taxes to be the single factor driving your investment choices."