by Gene Walden

Another school year has passed and your children or grandchildren are that much closer to college. If you haven’t already started to save for their college costs, this may be a good time to talk to your advisor about setting up a tax-sheltered college savings plan.

By planning ahead, you can use a 529 college savings plan to give your children a head start on their college costs. There are two types of 529 plans: college savings plans and prepaid tuition plans.

College savings plans are state sponsored investment accounts that allow participants to contribute regularly. A 529 plan account grows tax-deferred and withdrawals from the plan for qualified educational expenses are exempt from federal income tax. There are no income limits.

Tax-advantaged plan contribution limits can vary from state to state. But the key to all of the plans is your ability to set aside money for college that can grow tax-free.

For instance, in Minnesota, contributions to the College Savings Plan may qualify for an annual federal gift tax exclusion of $12,000 per donor, per beneficiary for 2008. If the contribution to a Minnesota College Savings Plan account for a beneficiary in a single year exceeds $12,000, the account owner may elect to treat up to $60,000 of the contributions, or $120,000 for joint filers, as having been made over a period of up to five years for federal gift tax exclusion.

The Pension Protection Act of 2006 made permanent the provision that the earnings portion of any distributions used to pay for qualified higher education expenses will be free from federal and state income tax.

Parents are not the only ones who can set up 529 accounts. Grandparents, relatives, and friends who are US citizens (or resident aliens) may open accounts and contribute to 529 plans.

Although there are limits on your tax-advantaged contributions, there is no annual limit on the amount you may contribute. However, there is an overall maximum account balance limit of $235,000 which applies to all accounts opened for a beneficiary. An account owner may contribute to a beneficiary’s account if, at the time of the contribution, the total balance of all accounts for that beneficiary does not exceed $235,000. Accounts that have reached the maximum account balance limit may continue to accrue earnings.

If the child for whom the account was originally opened decides not to go to college, the 529 rules allow you to designate another child as the beneficiary for your account.

The other college savings option is a prepaid tuition plan. These plans are offered primarily by state colleges and universities to help you lock in today’s prices for tomorrow’s tuition costs. A prepaid tuition plan allows you to pay in advance to cover your child’s fees and expenses. If your child decides to attend a college in a different state, these plans allow you to transfer the value to out-of-state public and private colleges.

If you’d like to help your children or grandchildren with college costs, ask your financial planner about setting up a 529 plan.