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The Internal Revenue Code created a college savings plan in 1996 called the 529 Plan. It's named after Section 529 of the Internal Revenue Code.
Even though 529 Plans are operated by each state, you can use a 529 plan to meet the costs of any qualified college nationwide. You may live in New York and invest in a NY 529 plan, and your child may use the funds for a college in California.
All states have at least one 529 plan available, and the plans differ from one state to the next. Depending on who manages the accounts, there are different fees associated with each 529 account and you can do a little research and find the plan with the lowest fees. Most states offer tax incentives to investor of 529 plans, and federal tax law provides a number of special tax benefits that make investing in these educational plans easy.
There are two ways to enroll in a 529 plan: you can either apply directly with a 529 plan manager in your state, or through a financial advisor.
529 Plans are categorized as either a savings plan or a prepaid plan:
Savings Plans: similar to 401K or IRAs. You choose how to invest in mutual funds or similar investments. Your account value increases or decreases based on the investments you select.
Prepaid Plan: allows you to prepay for public college educational costs. You can also convert those savings to use for out-of-state colleges or private institutions with the Independent 529 Plan used for private colleges.
Opening a 529 plan for young children is a smart move. They have many years to maximize the savings before they'll head off to college. Most 529 plans allow you to set up automatic deductions from your bank account to fund the account; and there are a variety of services that make it possible to receive gifts from friends and family to your 529 account: including FreshmanFund.com and Upromise.com.
The biggest concern parents have about opening a 529 account is what happens to the money saved if your child doesn't go to college? If they withdraw the money for non-educational expenses, it will cost them a penalty fee. However, 529 accounts can be transferred to any family member – so if a sibling decides to go to college, that money can be transferred with no fees to the other family member (or perhaps even saved for your grandchildren!)