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Consider how you will pay for a college education

First the grim news: The cost of a college education has continued to increase at rates well above the general inflation rate in recent years.

Now the good news: Your options for setting aside college money in tax-efficient investment accounts have increased as well. We’ll examine three of the most popular: 529 plans, custodial accounts and Coverdell accounts.

The Lowdown on 529 Plans

Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions.

College savings plans — a type of 529 plan.

Many of these plans are national plans: no matter which state or school sponsors them, residents of any state can participate. The potential advantages of 529 plans include:

4 Tax-free earnings — Earnings in a 529 plan accumulate free from taxes, and qualified withdrawals are federally tax free. Withdrawals may be exempt from state taxes as well (tax rules vary from state to state). Nonqualified withdrawals from a 529 plan may be subject to income taxes and a 10 percent additional federal tax.

4 Gift tax benefits for contributors — A contribution to a 529 plan is considered a gift for federal tax purposes. Tax rules currently let you give up to $13,000 in 2011 to as many individuals as you choose, free from federal gift taxes. Gifting schedules can also be accelerated through a lump-sum contribution of $65,000 to a 529 plan in the first year of a five-year period.

4 Generous contribution rules — Lifetime contribution limits on 529 plans vary from state to state, but often exceed $200,000 per beneficiary, including earnings. In addition, there usually are no income restrictions on contributors to a 529 plan.

4Account control — The individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account. This is not the case with Coverdell Education Savings Accounts or certain types of custodial accounts. Account owners may also change beneficiaries. Finally, contributions to 529 plans may provide a state tax deduction for residents of the sponsoring state.

As with all tax-related decisions, consult your tax advisor. Withdrawals for expenses other than qualified education expenses are subject to income tax and an additional 10 percent penalty on earnings. You should consider a 529 plan’s fees and expenses such as administrative fees, enrollment fees, annual maintenance fees, sales charges and underlying fund expenses which will fluctuate depending on the 529 plan invested in and the investments chosen within the plan.

You should also consider the inherent risks associated with investing in 529 plans, such as investment return and principal fluctuation, which will also vary based on the investments made within the plan. More information is available in each plan’s official statement, which should be read carefully before investing.

Key Smith is an associate with Henry Wealth Management in Natchez.