As higher education costs continue to soar, many parents find themselves faced with the nagging question, "Will I have enough money to pay for my child's college education?" Although most people today are likely to agree that an investment in higher education usually reaps its rewards in higher long-term earnings - and hopefully, greater job satisfaction-one key concern is how to choose a smart savings alternative. The Economic Growth and Tax Relief Reconciliation Act of 2001 offers additional incentives for saving to help fund higher education expenses.

One often overlooked option is a state-sponsored qualified tuition program (520 plan). These plans offer attractive tax benefits while allowing you to contribute substantially higher sums then with other savings vehicles, such as the Coverdell Education Savings Account (formerly known as the Education IRA) and custodial accounts. The funds may generally be used for any "qualified" higher education expense, including tuition, room, board, fees, books, supplies and equipment. You don't necessarily need to be a resident of a state to participate in its 529 plan. In some states, you may even name yourself as the beneficiary, if you are planning to further your education sometime in the future. However, participation does not guarantee admission to college-the prospective student will still have to meet the school's entrance requirements.

Although many details of these plans vary by state, they generally come in two forms. The first form-prepaid tuition programs-allows participants to "lock in" tuition rates at eligible state colleges or universities with a lump sum investment or monthly installment payment. The funds are pooled and invested over the long term, so the earnings should meet or exceed expected future tuition increases. The contract value may also be applied to private or out-of-state schools (although possibly not at full value, depending on the estate). The second form-savings programs-allows contributions to vary. The full value of the account can be applied at any accredited institution of higher education nationwide.

Major Advantages

Substantial Contributions Allowed. Contribution limits are significantly higher than with other college savings alternatives. Some states allow you to set aside over $100,000 per beneficiary, and they generally have no age or income restrictions.

Tax Benefits. Earnings grow tax deferred, and if used for qualified education expenses, are tax free (through the year 2002). In addition, some states offer their own tax breaks, although you may need to be a resident of that state. In contrast, traditional custodial accounts do not offer tax-deferred growth.

Special Estate Planning Features. Contributions to 529 plans are subject to gift and generation-skipping, transfer taxes. However, a unique feature of these plans is that they allow you to transfer up to five years' worth of annual gift tax exclusions in one calendar year, as long as no additional gifts are given to that individual during the five year period. For 2002, the annual gift tax exclusion amount is $11,000 ($22,000 per married couple). Also, unlike with a custodial account, you retain control of the account. Beneficiaries generally have no rights to the funds. You decide when and for what purpose funds are withdrawn (although you may be assessed a penalty for a "nonqualified" withdrawal).

Switching Funds Tax Free. Probably the most positive effect that the Tax Relief Act of 2001 had on 529 plans is that now you are able to switch funds from one 529 plan to another 529 plan free of any taxes. This allows you to make a switch as frequently as once a year without changing beneficiaries, and also allows interstate plan transfers.

Expanded Beneficiary List. Grandparents may be pleased to learn that under the Tax Relief Act of 2001, the list of possible beneficiaries has been expanded to include cousins. For example, grandparents with multiple grandchildren can set up a 529 plan for their first grandchild. Should that first grandchild choose to delay pursuing an education, the grandparents may transfer the plan to another grandchild.

Other Considerations

Professional Asset Management. 529 plans offer a "hands-off" savings approach. Funds invested in the plan are professionally managed through the appropriate state treasurer's office or by an outside investment firm hired by the plan.

Penalty for Refunds. A federal 10% penalty may be imposed on the earnings portion of a nonqualified withdrawal in addition to ordinary income tax. However, you may be able to roll over the account to a new beneficiary to avoid a nonqualified withdrawal.

Effect on Financial Aid. Any investment may affect a student's eligibility for financial aid. Interested organizations are attempting to clarify exactly how 529 plans will affect federal financial aid. For many families who earn less than $50,000 and file 1040EZ or 1040A tax forms, a 529 account may not be counted at all. Others, in higher income brackets, may want to open the account in the parents' names, since financial aid offices typically count only 5.6% of parental assets compared to 35% of the student's assets. For more specific information, refer to the particular state plan that interests you, and consult a knowledgeable professional.

Worth "Studying"

Those considering establishing a 529 plan should be aware that the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 makes several generally favorable changes to federal law governing 529 plans. These provisions are currently scheduled to "sunset", or expire, at the end of 2010 unless Congress intervenes. Since 529 plans also operate under the individual state laws, costs and details vary by state. Fore more information, and to compare state plans, do a little "homework" and visit these websites: Savingforcollege.com and Collegesavings.org.

No guarantee rate of return. Out-of-State plans may have in-state income tax ramifications. Always ask for, and refer to, the program description for complete information, including risks, fees, and expenses. Read it carefully before investing.