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Forget fuzzy socks, consider a 529 plan for Christmas

Kelly Phillips Erb is a tax attorney in the greater Philadelphia, PA area, where she focuses on tax law for businesses and families. She is also a freelance author and writer.

Kelly has published Ask the TaxGirl: Everything Parents Sh...

The gift parents (and kids) will truly appreciate

Admit it — every holiday season, while you're out picking up decorations and snapping up hot toys, you are secretly dreading those seven words: What do the kids want for Christmas?
College fund
A gift that really matters

saving with
a 529 plan

Admit it — every holiday season, while you're out picking up decorations and snapping up hot toys, you are secretly dreading those seven words: What do the kids want for Christmas?

It can be stressful when well-meaning parents, grandparents, godparents, aunts and uncles start asking you questions about what to buy for the holidays — especially when your kids are young. It's uncomfortable to think about spending other people's money and it can feel tacky to direct them to buy — or not buy — a certain toy for your little ones.

It's easier to be dismissive with a wave of your hand, and just say, "Whatever you think they'd want." But you know what happens when you do that — suddenly you're stepping over piles of Magna-Tiles and discarded Furbies in the living room because you didn't have the heart to say, "No more."

Make a plan

What about, instead of the usual suspects like fuzzy socks and Christmas sweaters, you consider telling your well-meaning loved ones about a 529 plan?

A 529 plan is an education savings plan created for the purpose of paying for college. The 529 in the title of the plan is a nod to the section of the Internal Revenue code (section 529) that outlines the basic criteria for the plan. And even though it was created by the federal government, each plan is administered at the state level. Today, you can locate a 529 plan in all 50 states, plus the District of Columbia.

Read more on the true cost of sending kids to college >>

A gift that will keep on giving

The idea of a 529 plan is simple — pay for tomorrow's education at today's dollars. To do it, you have two basic options — a prepaid tuition plan or a savings plan.

You don't have to invest thousands of dollars initially, or even hundreds of dollars. You can open a plan in most states with as little as $25 and top them up as you go by writing a check or having money debited from your paycheck (I prefer the latter since I kept forgetting to write the check).

Learn about the best college savings plans >>

Is it deductible?

For federal income tax purposes, putting money in a 529 plan won’t result in a deduction. The earnings inside the 529 plan (as well as the withdrawals) will not be subject to federal income tax so long as you use withdrawals from the investments for eligible college expenses.

For state income tax purposes, however, you might get a bonus — depending on the state, you may be entitled to a deduction for making a contribution. Some states allow the deduction regardless of where the plan is located or used. And the best part is you that can be entitled to the deduction even if you’re not the parent.

That's where those parents, grandparents, godparents and other people come in. Instead of gift cards that go unused, savings bonds that are quickly forgotten or toys that get trampled, why not suggest a contribution to a 529 plan? It's a win-win at the holidays — your child gets a boost in the college savings department, you get some assistance towards paying for education and your loved ones may get a tax deduction.

You can even make it an annual tradition. In most states, there are no income limitations or age restrictions for making contributions.

Rollovers are easy

And if Grandpa is worried about what might happen if one child doesn't go to college — or is lucky enough to earn a full scholarship — the good news is that rollovers are easy. There are no tax consequences if you change the designated beneficiary to another member of the family. The definition of family is pretty wide open and includes not only children and siblings, but parents, grandparents, step parents, nieces and nephews, in-laws, a first cousin — as well as the respective spouses.

Funds inside of the plans must be used for eligible college expenses. Those include what you'd expect — tuition, room and board, fees, books, supplies and equipment. Eligible college expenses also encompass the cost of the purchase of any computer technology, related equipment and/or related services including internet access if they are used by the plan's beneficiary and the beneficiary’s family during any of the years the beneficiary is enrolled at an eligible educational institution. Pretty great, right?

Adding to your child's college fund >>

Beware of restrictions

Using funds from the plan doesn't cut in on other tax breaks. You can still claim the tuition and fees deduction, American opportunity credit or the lifetime learning credit in the same year that you take a distribution from the 529 plan so long as you don’t claim the same expenses for both benefits. In other words, no double-dipping.

There are some restrictions on use of the funds. The biggest, of course, is that if you withdraw money from the plan for a purpose other than eligible college expenses, you will be subject to federal income tax and an additional 10 percent federal tax penalty on earnings.

College is expensive

According to the College Board, the average in-state published tuition and fees at public four‑year institutions is $8,893 in 2013‑14; the average published tuition and fees for full-time students at private nonprofit four-year institutions is $30,094 in 2013‑14. These estimates don't even include room and board. That's just for one kid. For one year.

That's a huge burden for families. That's why a gift of a college education makes sense. Money contributed to a 529 plan — especially if the plan was created when the kiddos were really small — is a gift that will keep on giving.

More about family finances

What to deduct when you're expecting
How to effectively teach young kids about money
The ins and outs of paying your caregiver

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