Some people have been stashing money in 529 college-savings plans since their kids were in diapers. But even if you procrastinated and your child is already enrolled in school, contributing to a 529 account could save you hundreds a year.

The tax perks vary from state to state. Twenty-six states and the District of Columbia offer a state income-tax deduction for contributions to 529 plans that they sponsor (see our map for all the states that offer tax breaks). Five states — Arizona, Kansas, Maine, Missouri and Pennsylvania — offer a state-tax deduction for contributions to any 529 plan. Indiana, Vermont and Utah offer a state-tax credit for contributions to their state-sponsored plans. (A tax credit is more valuable than a deduction because it reduces your taxes dollar for dollar.) In addition to the state-tax benefits, earnings on your plan investments are tax-free if they are used to pay qualified expenses, such as tuition, books and fees.

How much you will save by making last-minute contributions depends on your tax bracket and the plan’s contribution limit. But the savings can be substantial. For example, if you are in the top, 6.85% tax bracket in New York, you will save $685 per year by contributing the annual maximum of $10,000 for joint filers to the state’s 529 plan and then withdrawing an equal amount to pay for current college expenses.

Not all plans are as generous, however. Two states that offer state-tax deductions pose problems for last-minute contributors. Michigan provides a deduction for net contributions, meaning your contributions minus your withdrawals. So if you contributed to Michigan’s 529 this year, you would have to wait until 2011 to withdraw the money to get the full deduction. Montana recaptures any state-tax deduction on withdrawals made within three years of opening the account.

If you use this late-contribution strategy, park your investment in the 529 plan’s most conservative option to protect the money from stock-market volatility. Plus, conservative alternatives, such as CDs and money-market and stable-value funds, charge the lowest fees among investments on a plan’s menu.

From Kiplinger’s Personal Finance magazine, September 2010

Our Reader

Who: Rachel Aptekar, 46
Where: Davis, Cal.
Question: Should I use spare income to slash mortgage debt or invest in a 529 plan?

A part-time biology instructor at two colleges, Rachel earmarks $12,000 a year for her family’s future. Her top priority is to save for college for her three children — a commendable goal, but more complicated than it seems. In fact, her solution appears to be to do something unexpected.

Rachel is considering two options: Burn the family’s mortgage by 2013, a year before Laura, 14, graduates from high school, or invest $1,000 a month in college-savings accounts for all three children (including Dylan, 12, and Wesley, 10). With a state-sponsored 529 college-savings account, earnings are tax-free if used for tuition, books, school fees, or room and board.

Retirement is key. Rachel and her husband, Christopher Cassels, first need to review their retirement savings. When college bills come due, kids and their parents can use current income or scholarships, or they can borrow. But you can’t get loans to fund retirement. Christopher, 44, a county government supervisor, contributes to an investment plan for public employees and to a Roth IRA. An extra boost from Rachel would help shore up the family’s retirement security. Plus, Rachel and Christopher could withdraw their Roth contributions tax-free and penalty-free at any time for any purpose, including education.

But there are exceptions, and Rachel and Christopher are that rarest of couples who could own their home free and clear before their children are out of their bedrooms. They have a 15-year loan at a fixed rate of 5%, and they figure the house is worth about $400,000. If Rachel whacks away at the principal with full force, the mortgage stands to be paid off by 2013. Their monthly cash flow would be vastly improved, and they’re not worried about losing a tax break by paying off a mortgage early. They don’t get any tax benefit from paying mortgage interest now because they use the standard deduction — at $11,400 for 2010, it’s bigger than all their itemized deductions combined.

The college angle. The formulas for how much parents are expected to pay for college differ between public and private schools. The federal formula, which governs federal financial aid and public-college awards, does not consider home equity. Many private schools do factor it in, however, so a paid-off house is a disadvantage. Money in a 529 plan can also restrict aid.

Nevertheless, the family should still qualify for some assistance because there will be two, and possibly three, siblings in college at the same time, all being financed on a middle-class income. That situation will count in their favor when it comes to financial aid, especially if the children apply to public colleges.

Bottom line: Rachel should lean toward extra mortgage payments. If all else stays the same, she’ll eventually have $12,000 a year, plus the thousands the couple conserve by not owing on a mortgage, to cover college costs or expand retirement contributions. Less debt equals more flexibility.

From Kiplinger’s Personal Finance magazine, April 2010

The college hunt is a parade of choices. Private or public. In-state or out-of-state. On-campus or off-campus housing. But when it comes to saving for school expenses, one choice is a clear winner — a 529 savings plan.

Taking advantage of one of these state-sponsored plans is a no-brainer. A 529 plan shields your investments from federal income taxes, gives grandparents an easy way to boost their grandkids’ college fund, and barely dents your chances for financial aid. And more than half the states sweeten the deal with a state income-tax deduction or credit. Investors have flocked to 529 savings plans. Assets grew from $11 billion in 2002 to $119 billion in 2009, and the average account balance is $12,000 — about one year’s tuition at a public university.

Take the tax break

You don’t have to invest in your state’s plan, but if your state gives you a tax break, it’s often best to stay close to home. Thirty-four states plus the District of Columbia offer state income-tax benefits for 529-plan contributions. Five states provide a tax benefit regardless of which state’s 529 plan you pick. Alabama uses a stick rather than a carrot: It doesn’t tax distributions from its own plan, but it levies a tax on distributions taken from other states’ plans. See our picks, state by state.

With any 529 plan, your savings grow free of federal income tax. Distributions escape federal income tax altogether if you use the money to pay for qualified educational expenses — mainly tuition, fees, books, and room and board (you can use 529 money in 2010 to pay for a computer, but that perk is set to expire at the end of the year).

The accounts are flexible. If Junior doesn’t want to go to college, you can transfer the funds to another family member and preserve the tax benefits. Or you can withdraw the money and pay income tax and a 10% penalty on the earnings. Unlike other education-savings programs, 529 plans allow families to participate regardless of income, and the states set a high ceiling on contributions (usually up to $300,000 per account).

Don’t worry that a 529 will cripple your chances for financial aid. The federal financial-aid formula counts 5.6% of parent-owned accounts as part of the expected contribution to college costs — a relatively painless hit compared with the 20% assessment on student savings.

Go the direct route

You can buy a 529 plan directly from each state or through an adviser. We prefer direct-sold plans because they don’t charge commissions or adviser fees like adviser-sold plans do. You’ll have to pay administration and investment-management fees with any 529 plan, however. Most states offer several investment tracks, which range from conservative to aggressive. More than 60% of investors put their 529 money on autopilot by choosing age-based portfolios, which automatically shift from stock funds to bond funds and cash as the student approaches college age.

Picking a plan is a bit more complicated if you live in a state that doesn’t offer a 529 tax break. Depending on what you’re looking for, go with one of five plans that rise to the top of our list:

Low fees. We like the index portfolios in the Illinois direct-sold Bright Start College Savings Plan. The portfolios, which include mostly Vanguard funds, charge rock-bottom fees, which range from 0.20% to 0.22%.

Ready-made portfolios. Ohio’s CollegeAdvantage 529 plan offers great choices from Vanguard, Pimco and GE Asset Management, as well as certificates of deposit from Fifth Third Bank.

Low risk. Savers who shy away from stocks should check out the Michigan Education Savings Program. It has an option that guarantees principal and doesn’t charge an annual fee.

Varied menu. Fund pickers can benefit from the direct-sold College Savings Plan of Nebraska, with its selection of 20 funds from American Century, Fidelity, Pimco and Vanguard. The wide assortment does come with higher fees; the most expensive fund option costs 1.64% annually.

Adviser-sold fund. If you feel more comfortable going this route, the Virginia CollegeAmerica plan is a standout among adviser-sold 529s.

The drawbacks

The plans do have a number of drawbacks, but there are ways around them. You can change your 529 investment choices only once a year, which can hurt (or help) if you’re tempted to tinker. One alternative is to go with a set-it-and-forget-it option, which does the tinkering for you.

Like just about every other investment, 529 plans took a big hit during the recent bear market because they turned out to be riskier than expected. As a result, a number of states, such as Colorado, Kansas, Utah and Wisconsin, have added bank CDs, FDIC-insured savings accounts, U.S. Treasuries and money-market funds to their investment lineups.

As for fees, expect them to fall as assets grow and managers vie to attract more customers. Last December, Fidelity cut management fees in half for its index portfolios and by one-third for its actively managed portfolios for five direct-sold 529 plans it runs. The Utah Educational Savings Plan, one of the lowest-cost 529 plans, reduced fees on some investment options in February.

From Kiplinger’s Personal Finance magazine, June 2010

From Kiplinger’s Personal Finance:

Finally, a birthday gift that’s fiscally responsible. Instead of giving children more toys, DVDs or video games, family members and friends can easily contribute toward a child’s college kitty.

Click here for the entire article.

From Kiplinger’s Personal Finance magazine:

It sounds like a great perk. You invest in a college-savings plan selected by your employer, and contributions are automatically deducted from your paycheck. Result: a no-sweat college kitty. Unfortunately, it’ not that simple.

Click here for the entire article.