With stocks down 40% in the last year and key indexes threatening to fall further in 2009, many parents fear that six or seven years of college savings could be down the drain.

Then again, maybe not. Parents with longer investment horizons could make a smart financial move by taking money out of taxable investment accounts and moving them into a college 529 plan.

A college 529 plan is a tax-advantaged educational savings plan, usually sponsored by a state or educational institution, which enables families to allocate money for future college costs. While these plans were created by the federal Government, it’s up to individual states—all 50 as of 2008—to design and deploy the plan to their satisfaction.

Your College Saving Options
Currently, states are offering two primary types of 529 plans:

  • Prepaid Tuition Plans: These guarantee the money you save today will match the growth in tuition inflation at state-run colleges and universities, essentially locking in tomorrow’s prices in today’s dollars. With budgets strained these days, prepaid plans especially appeal to middle-income families who are aiming for a state college or university.
  • College Savings Plans: These plans allow you to contribute to a pool of money managed by the state treasurer or an outside investment adviser. A typical savings plan leans toward stocks when the child is young, then moves toward bonds and cash as college draws near. A few plans offer all-stock or all-bond accounts. You can use the money at any accredited school for tuition, room, board, books and supplies. If your state's plan is inferior or doesn't disclose performance and fees, you can invest in another state. It’s up to the states to decide who is going to run the plans, and in most cases it's a Wall Street brokerage or mutual fund firm.

From an investment point of view, 529 plans are a lot like 401(k) plans. They’re usually managed by a single investment advisor, but investors get to choose from stock, bond and money market funds. By and large, parents can be more aggressive when their kids are younger, and pursue small cap, large cap and even some international funds. But as the child gets closer to collegiate age, capital preservation becomes a priority, as investment options shift to more conservative fixed income funds.

By and large, it doesn’t matter if schools you’re targeting are outside your state. If you live in Pennsylvania, you can invest in a Rhode Island-based 529 plan, and attend the University of Massachusetts. Every state in the U.S. now offers a 529 plan, and you can check the eligibility of the school your family is considering.

Tax Benefits
529 plans can be loaded with tax benefits. For instance, principal and asset growth in 529 accounts are tax-deferred. Better yet, investment distributions, thanks to the Pension Protection Act of 2006, are deemed tax-free by the IRS as long as they’re used for qualified college expenses. That means any money you contribute to a 529 plan, and any interest you may earn on those contributions, will not be taxed. When you take money out of a 529 plan, that won’t be taxed, either. That said, contributions to a 529 plan are not tax deductible on your federal tax return. But state rules on 529 plans may differ, with some states allowing a deduction for contributions or income exemption on plan withdrawals. For instance, Pennsylvania residents can deduct contributions to any 529 plan, up to $13,000 per beneficiary in 2009. Check the tax impact of your state’s 529 plan.

Tips on Finding a Good Plan
If you decide a 529 plan is a good fit, take some time to do some comparison shopping first. Start by checking with your own state’s plan to see if it offers compelling state-tax advantages.  Be sure to compare other important plan details, like whether or not funds may be used for graduate studies, part-time studies, room and board, or just tuition expenses. Also ask about the plan’s minimum and maximum allowed contributions. In New Hampshire, for example, the maximum allowable contribution for one child is $330,000. The minimum opening contribution for New Hampshire 520 plans is $1,000, with a $50 minimum investment every month.

Also know that the figure you decide to invest on a regular basis is the figure that your state’s plan will hold you to during the length of the plan. That means, for example, $100 a month now and $100 a month until you take control of the assets when your child marches off to campus. Also look out for varying rules concerning divorce. Each state has different regulations regarding the splitting up of 529 plans after a divorce.

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