How to Set Up a 529 Plan for Your Child

A 529 college savings plan is an investment account that allows you to set aside money for your child's education and let it grow tax-free. All 529 plans are administered by individual states, but you can invest in any state plan that meets your needs. If you're not a resident, however, you may face higher commission rates and more limited investment options. If you choose your own state's plan, you may enjoy state tax benefits.

Instructions

Difficulty: Moderately Challenging

1. Look first at your own state plan. All 529 savings plans provide the same federal tax benefits and withdrawals are untaxed as long as you use them to pay higher education bills. 32 states and the District of Columbia offer residents a write-off on state income taxes for at least a portion of their 529 contributions. Three states, Kansas, Maine and Pennsylvania, also allow residents to deduct their contributions to out-of-state plans.
   
   If you live in a high-tax state that offers a big deduction for 529 contributions, your best 529 plan is one in your own backyard as long as the plan also has reasonable expenses and offers solid investment choices.
2. Keep your expenses low. High management, marketing and administrative fees can cancel out the tax savings on 529 accounts and drag down your returns. For example, TIAA-CREF recently reduced fees on its Michigan plan from 0.60% to 0.45%. You will typically find lowest costs among direct-sold 529s, such as Utah's Education Savings Plan, with expenses of 0.38% or less. Try to limit your choices to in-state plans that charge less than 1% or national plans with expenses below 0.7%.
3. Pick funds that match your style. In addition to lowering their fees over the past year, 529 plans have been overhauling their menus of stock and bond funds by adding index portfolios and actively managed options. Many 529s offer three or four age-based mixes that range from aggressive to conservative; pick the one that suits your tolerance for risk. For example, a moderate investment allocation for an 8-year old, might be a 60-40 mix of stocks and bonds. If you decide to manage your own portfolio, you can make an investment change only once a year.
4. Perform an annual checkup. Review your account at least once a year to make sure your investments are on track. Watch for changes in your state's provider. If your plan does switch, look closely to make sure the expenses are still reasonable and the fund choices are solid. If you decide to stay in the plan, your account will automatically shift to a similar offering at the new fund group unless you request otherwise. If you don't like the change or decide to move for other reasons, it's easy to switch to a different 529. You are allowed one rollover a year.
5. Make a withdrawal from your 529. By filling out a form, you can arrange for the money to be sent directly to your child's college, which can simplify your tax records. Under IRS rules, the payment of expenses and the withdrawal of 529 funds must take place within the same calendar year to qualify for tax-free treatment.

Tips & Warnings

• You can use the money in a 529 plan at any accredited college or university in the country — public or private, graduate or undergraduate.
• The money can be used for tuition, fees, room and board, books, supplies, and equipment.
• You can open accounts for any number of people, regardless of age and regardless of their relationship to you.
• What you don't get is an up-front federal tax deduction - think of these accounts as the college saver's counterpart to Roth IRAs.
• Many 529 plans still charge more than you'd pay if you bought the same fund directly from the fund company.
• Investment options are limited by what is offered by your state.
• If you don't use the money for school, you'll pay heavy penalties.