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College-Savings Plans Get More Complex

The first 'independent' 529 plan has been launched by more than 200 private colleges.

Like many other bright ideas rooted in the tax code, the 529 plan -- designed in 1996 to make saving for college much easier -- has become increasingly complex. And this month it got a little more complicated.

Until now, 529 plans have all been sponsored by a particular state. These state-sponsored plans each employ their own set of Byzantine rules, but all provide a plethora of tax advantages. Now, however, the first "independent" 529 plan has been launched by a consortium of more than 200 private colleges. And yes ... it has its own unique rules, too.

Broadly speaking, 529 plans (elegantly named for the section of the tax code that "created" them) can be placed in two categories: prepaid programs and savings programs. Each has its charms.

Prepaid plans essentially guarantee that if you pony up a specified amount now, you're guaranteed to have future tuition covered at a state school. Most states offering these plans will allow you to transfer the value of your account to private or out-of-state schools -- good news if the little darling decides on an Ivy that's 2,000 miles away.

Savings programs are just that: essentially, big, tax-advantaged accounts.

The Independent 529 plan is another animal altogether, although it does qualify for federal tax treatment under Section 529 of the tax code. The Independent plan will allow families to immediately lock in a percentage of a participating college's tuition costs for a future year.

All plans allow for multiple contributors, so you need only open one account per child.

But let's back up a moment. Both types of state-sponsored plans offer essentially the same breaks. Think of these accounts as Roth IRAs -- there's no federal tax deduction for contributions, but your investment grows tax free for as long as it's in the plan. And thanks to President Bush's 2001 tax law, all distributions that go to pay for the beneficiary's college costs will be completely tax free.

Unfortunately, thanks to the same law, this provision disappears after 2010 unless Congress makes it permanent. If not, after 2010 distributions from that tax-free growth will be taxed at the beneficiary's income tax rate. (Like a Roth, the money that was contributed won't be taxed at the federal level, only the gains that had thus far escaped taxation.)

Most states offer some sort of tax break to residents who invest in their own state's 529 plan. That break is often in the form of an upfront deduction on contributions and/or an exemption from state income tax on withdrawals.

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With the Independent 529 plan, state tax breaks are nil, but federal breaks will apply.

The Independent plan is similar to a prepaid tuition plan -- and that means virtually zero investing options for contributors. Instead, the colleges bear the burden of investing the contributions and guaranteeing the "certificates" people buy will cover tuition costs.

TIAA-CREF will administer the plan and manage all the funds. There are no sales, application or maintenance fees assessed to account holders.

Here's how it works: Contributors purchase certificates, each of which represents a certain percentage of a future year's tuition. That can be 30% or 100% of tuition -- depending on the college attended and the length of time before attendance. You don't need to buy a certificate for a particular college, but the percentage will differ from school to school. For instance, a $5,000 certificate might buy you 30% of a year's tuition at one college, but 50% at another. Member colleges run the gamut academically, geographically and sizewise.

In addition, the member college must discount its tuition by at least 0.5% in setting its percentages. That's a marked difference from many state prepaid plans that charge premiums over current tuition levels.

This plan does offer some of the same flexibility offered by traditional 529 plans. After an account has been open for a year, the certificate can be refunded to the purchaser, or rolled over tax free to another 529 account. The certificate's refund value is equal to your original purchase price, adjusted (either upward or downward) by the actual investment return the plan has earned.

That adjustment, though, is capped at 2% -- so you'll never lose more than 2% of your investment, but you'll also never see a return of greater than 2%. And like other 529 plans, withdrawals not used for qualified higher-education expenses are subject to income tax on earnings and a 10% penalty.

The 2% cap is a huge drawback if your little dearie wants to go to a school that's not one of the 200 plan participants. The refund value of your certificates won't be worth as much at an outside school. Otherwise, the plan -- while brand new -- seems worth looking into. You can find more information at the

program's Web site, or send any further questions my way at

bgoodman@thestreet.com.