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Is a 529 college savings plan a safe investment?

March 28, 2012: 6:00 AM ET

I want to start a 529 plan for my kids (12, 8, and 7). But I worry that my state is not doing well with managing pensions and the prepaid tuition program they sponsor. Should I be worried that a 529 investment is safe? Are there other alternatives to a state-sponsored 529?
-–Denise, Sycamore, Ill.

Prepaid tuition plans have been in the news of late, and the news hasn't been good—Illinois is just one of several states with an underfunded plan. A 529 college savings plan, however, works differently, and your state's financial status should have no effect on one.

With a prepaid tuition plans, you pay now for future tuition credits at a particular in-state school or group of schools; with a 529 savings plan, your contributions are invested in funds run by outside companies, and you can use that money at any college you choose.

Take, for example, North Carolina's 529, says Mike Palmer, a financial planner in Raleigh, N.C. "North Carolina uses Vanguard funds as the underlying investments in its 529 plan. So North Carolina's credit rating and the state's financial status have no impact on the safety of the plan." In other words, Vanguard is managing your money, not the state government. In Illinois, which has a few options, one of the state 529 plans is managed by a subsidiary of Oppenheimer Funds.

You don't have to stick to the 529 in your state, although you may get a tax break for doing so. In Illinois, you can deduct up to $10,000 in 529 contributions on your state taxes. (Up to $20,000 for a married couple.) If you feel strongly about investing in another state's plan, you'll have to decide whether it's worth giving up your own state's tax advantage.

There are alternatives to a 529 plan, including a Coverdell Savings Account, but you can't put in more than $2,000 a year, and those contributions aren't deductible. You can also use a Roth IRA to save for college, but most planners would rather you use a Roth for your retirement. (You can open a Roth for your kids if they have earned income of some kind.)

In the end, a 529 is your best college savings option. You'll pay no taxes on the earnings as long as you use the money for qualified education expenses, and you may get a tax break on your state taxes for contributing. "The 529 tax advantages are far superior," Palmer says.

--Kate Ashford

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