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Farah Karim Hough:

If you're looking for ways to save for a loved one's college education, you may have heard about 529 plans. What are they exactly? They're named after the section of the IRS code that authorizes them. Basically, they're state-sponsored tuition savings plans, and they offer some attractive tax advantages.

There are two types of 529 plans, savings plans and prepaid tuition plans. We'll explore both in this video, beginning with savings plans, since they're the most popular option. First, they're easy and inexpensive to set up. They're similar to retirement plans.

When you contribute money to your plan, you invest those contributions in a variety of investment funds. Anyone, including parents, grandparents, other relatives, and friends, can make unlimited contributions. And many states offer state income tax deductions or credits for those donations. Contributions are also excluded from gift tax up to the annual gift tax exclusion amount.

What is the annual gift tax exclusion? Basically, each year the IRS allows you to give away a certain amount to as many people you want free from gift taxes. It's adjusted annually for inflation. And at the time of this recording, it's $19,000 per recipient.

For 529 plans, you can even superfund an account with up to five years worth of annual exclusions up front, with no gift tax implications. This allows you to get more money into your account sooner and give it more time to grow. If you'd like to learn more about gift taxes, please watch our "How Are Gifts Taxed Video?" Now, what about withdrawals?

From an estate planning perspective, tuition payments made directly to the institution are free from any gift taxes. Withdrawals are also free from federal and usually state income tax if they're used to pay for college expenses. And it's not just limited to tuition. This includes room and board, textbooks, computers and software, and similar expenses.

You can also use withdrawals for private K through 12 education, but only for tuition up to $10,000 per year. Two other main points to note here—

You can change the beneficiary if the new recipient is a qualified family member. It's a pretty broad definition and can include siblings, grandchildren, nieces or nephews, first cousins, and more. And finally, what if there is money left over in the account after college is done? Thanks to a recent tax law change, leftover amounts up to $35,000 can be transferred to a Roth IRA account for the beneficiary.

Now, there are potential drawbacks to 529 savings plans, and here are a few. Contributions must be made in cash. Investment options are limited. And like any investment, the assets are subject to market risk.

In other words, account values can rise and fall. If you withdraw funds for anything other than educational expenses, you may have to pay federal income tax on the earnings along with a 10% penalty. Now let's turn to the other type of 529 plan, prepaid tuition. They are less common than the savings plans we've been talking about, but they could be worth considering if they're available in your state.

What makes them attractive is that they allow you to prepay tuition at today's rates at eligible public and private colleges and universities, no matter how far in the future you'll need it. Most states guarantee that the funds you put into a prepaid plan will keep pace with tuition. But here are some things you should know. Most plans require residency by the plan owner or beneficiary in the state that sponsors the plan.

Most cover tuition only. And for in-state public colleges, the plan will pay full tuition costs. For private or out-of-state colleges, you'll only receive the average of the in-state public college tuition. So let's say your child attends a private college, and the annual tuition cost is $30,000.

But the average tuition for in-state public colleges is $10,000. So that's all you'd get. And you'd be responsible for the remaining $20,000. What else?

Any funds not used for educational expenses are subject to taxes and penalties. OK, now that we've covered some of the details, let's recap. 529 savings plans offer tax-deferred growth and tax-free withdrawals when they're used for qualified college education expenses. Funds can also be used for private K through 12 education, but only for tuition.

529 prepaid tuition plans lock in tuition rates at current prices, protecting against the rising cost of education. The bottom line is 529 plans can be a powerful tool to help save for education, but they may not be right for everyone. Or they may be best used in conjunction with other planning strategies. We discussed some of these in the next video in our series, "How to Save for Your Child's Education."

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