Changes add appeal to a college-savings plan

Weakened economy or not, college isn't getting any cheaper. But state-sponsored "529" college-savings plans are getting a lot more user-friendly, and could become a big source of college funds.

A 529 plan, named after that section of the IRS code, allows a sponsoring state to set up investment accounts that are meant to help pay for college. The donor puts money into an account, and the state - typically nowadays through a mutual-fund company that actually runs the plan - invests it in stocks or bonds in the hope of making enough money to pay for the ever-increasing cost of college.

The big difference between a 529 plan and a standard investment in mutual funds is tax breaks. In many of the 39 states that already operate 529 plans, annual contributions are tax-deferred. Michigan and Missouri, for instance, permit $10,000 write-offs to married couples filing jointly.

Better yet, thanks to recently passed tax-relief measures, qualifying withdrawals will be free of federal income taxes starting in 2002. Many states will follow suit and free up earnings from state taxes.

Besides that big tax windfall, lawmakers have made 529 plans more appealing by broadening their investment choices. Until September, Iowa offered one style of investing; now it offers four "tracks." They range from conservative to aggressive - and, from mostly stocks to mostly bonds - as investment choices.

Investors typically move from more- to less-aggressive tracks as the student approaches college age. And the IRS has just decided to allow account holders to change tracks once a year if they wish.

"It's definitely an improvement ... in offering more choices to investors," says Joe Hurley, author of "The Best Way to Save for College" and a leading authority on 529 plans. Mr. Hurley says he also likes two other tweaks that Congress has made to 529 plans. In the first instance, they have broadened the definition of family to include cousins, so money not spent by one student can be spent on a brother, sister, or now, a cousin.

Second, account holders can now transfer a 529 plan from one state to another. This is an important benefit to such a mobile society, especially since so many of the tax breaks are tied to the state of residency.

An existing benefit of 529 plans is that they provide a back-door way to retain control over the student's money. Traditional custodial accounts (also know as UTMA or UGMA accounts) require that ownership be given to the child once he or she reaches the age of majority - 18 or 21, depending on the state. A 529 skirts such arrangements, giving the donor the ability to ensure that the funds will be used for education.

If, for example, a youth named on an account decides to skip the undergraduate life, the money can be transferred to other family members with college expenses. (You can also spend the money yourself, but the earnings would be taxable, plus a 10 percent penalty.)

Another advantage to 529s is their accessibility. Accounts can be opened in some states with as little as $25. And contributions can be made regardless of an individual's income. Michigan, for example, will accept as much as $125,000 per year, and income limits that often exclude high-income taxpayers from federal tax breaks such as Hope Scholarships don't typically apply to 529s.

Often, 529 plans are marketed directly by the state treasurer's office, and all have toll-free telephone numbers and websites available to process applications. To learn details about 529s in a given state, visit Hurley's website (www.savingforcollege.com).

These plans are becoming so popular that stock brokers are now selling 529s, usually offering an out-of-state plan.

That's generally not a good idea, suggests Tom Pinto, a spokesman for TIAA-CREF, the giant educators' retirement-plan operator that administers 529 programs in 12 states. Brokers add fees and commissions that don't apply if you simply stick to the plan in your own state, he says. And you lose any state-granted tax breaks, as well.

There are some negatives to 529 plans. For example, they don't give the investor any say in how the money will be invested. That is left to the plan administrator. In addition, 529s don't guarantee a profit. The biggest foe that 529 plans face right now is a tough stock market. Many 529s have posted double-digit losses over the past year.

But some states have options that protect investors' principal. The Ohio College Advantage Savings Plan, for one, offers state backing on its guaranteed savings plan. It also offers a variable-investment option (not guaranteed).

Another guarantee is the College Savings Bank, of Princeton, N.J. It offers a certificate of deposit that is guaranteed to rise with hikes in tuition costs, says Peter Roberts, the bank's chairman. (Average tuition, and the CD rate, rose 5.2 percent in the year ending July 31.)

Still, 529s are meant to be long-haul investments, and over time, stocks generally outperform bonds and money-related instruments. So it's fair to assume that 529s invested in the stock market will eventually spring back to life.

While 529 college-savings plans provide many advantages, they do offer a limited number of investment choices.

Those who want a greater role in decisionmaking may favor opening a Coverdell Education Savings Account (formerly called an Education IRA).

Beginning next year, investors can contribute up $2,000 a year, up from $500. Contributions are not tax deductible. But withdrawals for education expenses - including private elementary and high school expenses - are tax free. Beneficiaries of these accounts must be 30 years old or younger.

In the past, parents had to choose whether to invest in 529s or education IRAs. Next year the restriction vanishes. You can invest in both tools. Coverdells are marketed by banks, mutual funds, and brokerages.