With the holiday shopping season fast approaching, gift givers have a couple of choices. You could battle for a deeply discounted flat-screen TV or Xbox that will make the little ones squeal with delight.
Alternatively, you could stay home and invest that money in a 529 college savings plan. This gift will no doubt convince your children that there really is no Santa Claus, but years from now, when they graduate from college without student loans, they'll thank you.
Saving for college has never been more important. Federal and state budget deficits could lead to cuts in traditional sources of financial aid, which means there's a good chance there won't be as much available when your child goes to college, says Joseph Hurley, founder of SavingforCollege.com.
Meanwhile, tuition continues to increase much faster than the rate of inflation. Tuition and fees at public colleges and universities rose more than 8 percent this year, according to a recent report by the College Board.
There are lots of ways to save for college, but none offers greater tax benefits than 529 savings plans. Earnings on your investments grow tax-free, and withdrawals aren't taxed as long as the money is used for qualified higher-education expenses.
Anyone -- parents, grandparents, aunts and uncles -- can contribute to a child's 529 account. If the beneficiary of the plan decides not to go to college, or gets a full scholarship, you can make another child the beneficiary. Alternatively, you can name yourself the beneficiary and use the money to go back to school.
Other reasons to contribute to a 529 plan:
Plans have gotten cheaper, and investment options have improved. In the past, some 529 plans were burdened by high costs and mediocre mutual fund portfolios. In recent years, though, the 529 plan industry has matured, says Laura Pavlenko Lutton, editorial director for Morningstar's fund research group, which tracks 529 plans.
Meanwhile, state plan administrators have used the competitive bidding process to lower costs. Through August, the average annual expense ratio for 529 plans was 0.87 percent, down from 0.94 percent for the same period in 2010, according to Morningstar's annual survey of 529 plans.
Plans have added conservative options. Many parents and grandparents are understandably anxious about investing their college savings in a stock market that seems to have lost its mind. In recognition of those concerns, many 529 plans have added conservative investments, such as certificates of deposit and stable value funds. Sometimes, these investments pay a higher interest rate than you could get from a bank CD, Hurley says.
These options may be a good choice if your child is in high school and you want to protect money you've already saved, Lutton says. They're not a wise choice for parents of younger children, she says, because returns from ultra-conservative investments are unlikely to keep up with tuition inflation.
Remember, too, that most 529 plans offer an age-based portfolio that shifts your money into more conservative investments as the child nears college.
You may be eligible for a reduction in your state taxes. Thirty-four states and Washington, D.C., offer state tax deductions or credits to residents who invest in their own state's plan. These tax breaks have escaped state budget cuts, Hurley says.
The size of these tax incentives varies significantly. Indiana, for example, offers a tax credit worth 20 percent of the first $5,000 in 529 plan contributions.
A couple with two children and an annual income of $100,000 could save $1,040 in taxes by contributing $5,000 to their home state's plan, according to a Morningstar analysis. If that same couple lived in Arizona and contributed $5,000 to Arizona's plan, they'd save about $63, Morningstar found.
Families that live in states with no tax break -- either because the state doesn't offer one or the state has no income tax -- should look for a plan that has the best-performing investments and the lowest costs, Lutton says. A good place to start is Morningstar's annual list of top-rated 529 plans.
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