In 1996, section 529 of the Internal Revenue Code created tax-deferred savings plans for parents to pay for their children's college education. Established individually by state (all 50 states sponsor at least one type of plan) and managed by the financial institution of their choosing, they've become a very helpful resource for parents as they find ways to fund their children's schooling.
The 529 works very much like an IRA. All contributions grow tax-deferred until they are withdrawn from the plan to pay for college tuition. There are two types of plans: the college savings plan and prepaid tuition plan.
The prepaid tuition plan allows those saving for college to buy credits today to cover future tuition costs at participating universities. In most instances either you or your child will need to live in the state where you've bought the credits. It's important to note that states usually guarantee the investments made in these plans. As for the college savings plan, parents contribute funds toward the plan and when needed, the child withdraws those funds tax-free to use for tuition at any university they choose to attend.
Some of the additional benefits of the 529 college savings plan include:
Most financial planners agree that the college savings plan is superior to the prepaid tuition plan because it provides the best overall option for parents. It doesn't mean that the prepaid tuition plan isn't a worthwhile product, just that the college savings plan offers more benefits.
For those interested in additional savings plans, there is the Coverdell Education Savings Account. The contribution levels are much lower but the funds can be used for schooling prior to university.