Prepaid Tuition Plans and State - Sponsored College Savings Accounts:

Prepaid tuition plans and state-sponsored college savings accounts are a very attractive way to finance a child's college education and the Tax Relief Act of 2001 supports them. Since 2002, these plans have been completely tax-free.

Prepaid tuition plans (now offered in most states), allow parents to lock in a child's tuition rate years before they enroll and thereby eliminating the worry of whether their savings will grow fast enough to keep up with the constantly rising costs for college.

Most states also sponsor tax-sheltered college savings accounts to which parents can contribute on behalf of a child. Mutual fund companies generally manage the accounts. These state plans are often called "529" plans (after the tax code that authorized them).

Contributions to these plans can be as much as $305,000. An individual can contribute a maximum of $55,000 ($110,000 married couples) per beneficiary in any single year provided another contribution is not made for the next five years. The funds invested in a Section 529 Plan grow tax-free until it's withdrawn at which time the earnings are taxed at the student's rate, typically lower than the participant's rate. Based on annual contributions, some states also offer added benefits, which include state tax exemptions on the earnings and deductions from income taxes. Section 529 also has some powerful estate tax benefits too. All contributors to the plan receive a matched deduction to their estate that reduces estate taxes.

An individual who is the beneficiary of the plan may claim the plan for qualified higher education expenses. For the purposes of the plan, qualified higher education expenses includes, tuition, room and board, books and fees, and any other expenses that students are required to pay to attend any accredited college or university in the United Stated, and some international institutions. There are penalties for non-qualified withdrawals. In addition to paying taxes on non-qualifying withdrawals, there is also a penalty on the earnings, 10 percent, if the funds are not used for higher education.