This article originally appeared in the August 2009 issue of Smart Business Philadelphia magazine.

With the growing concern over market stability and its effect on both short- and long-term investments, future students and their families have become more tentative about adding to their college funds. And those who are still actively saving are looking for a more effective and straightforward strategy.

"As college costs continue to increase, many are looking for smarter ways to save. Currently, the most popular product available is the 529 plan," says Mark Anderson, a director in the Tax Strategies Group at Kreischer Miller. "These plans function simply, and the best part is that getting involved in one is easy for most families."

Smart Business spoke with Anderson about how 529 plans compare to other education savings options and how to avoid the tax consequences of paying for a loved one’s education.

How do 529 plans differ from other educational incentive options?

529 plans are more sophisticated than some of the other education credits and tuition deductions available to taxpayers and offer a variety of unique benefits not found in other education savings options. Traditional education credits act to reduce your tax liability, preventing you from receiving a tax refund if you have no liability. In addition, education credits are reduced when adjusted gross income exceeds certain amounts. For 2009, the phaseout begins at $50,000 for single taxpayers and at $100,000 for joint filers.

529 plans are not subject to income limitations and can be utilized by all taxpayers. While there is no tax deduction or credit for amounts contributed to a 529 plan, the investment income and/or increase in the plan’s underlying value are not taxable as long as the funds are used for education expenses.

Other educational savings options carry far more limitations to how the funds may be spent, making them less desirable alternatives. 529 plans are also universally available to families in all tax brackets, making them attractive to both higher- and lower-income families.

How are 529 plans structured?

Typically, there are two main types of plans — prepaid plans and investment plans. Prepaid plans, also known as state plans, are set up by a state or political subdivision. Benefactors may buy credits in today’s dollars, allowing the beneficiary to use them to pay for credits in the future. They may also be arranged as an investment plan with a related investment account. Depending on how the plan is invested, it will produce investment gains.

All of these options provide funds for tuition and fees, as well as books, supplies, and room and board for half-time students. Computer equipment and Internet access are now also considered qualifying expenses.

What are the gift tax implications for donors?

An individual may contribute up to $65,000 at one time to a 529 plan without incurring gift tax by claiming a pro-rata gift tax exclusion of $13,000 a year over each of the next five years. If a donor chooses to contribute more than $65,000, the additional funds would be considered a taxable gift and may subject the donor to gift tax.

Donors who are considering funding educational expenses for students currently attending college should be aware of the general educational expense gift tax exclusion, as well. Under this provision, an individual is entitled to an unlimited exclusion from gift tax for another individual’s school tuition if the payment is made directly to a college or a university; this exclusion is in addition to the annual exclusion.

Are there other benefits or limitations to 529 plans?

You may not contribute stocks, securities or any other type of property into a 529 plan; this is a cash-only endeavor. However, the current market situation may work to your advantage when considering college savings.

If you have other capital gains, you can liquidate investments that may have lowered in value and contribute the cash, tax free, to a 529 plan. This would trigger a capital loss that you could use to offset other income.

Another benefit of 529 plans is that they are transferable from student to student. In the event that the initial beneficiary is unable to use all of the funds in the account, the remaining funds may be transferred to a second beneficiary.

One major limitation does exist, however. When purchasing tuition credits in a state plan or arranging the funds in an investment account, neither the donor nor the beneficiary may participate in the decisions to change the investments more than once a year.

With the drop in the market last year, and growing concern over being locked into plummeting investments, a special exception has been created for 2009 and changes will be granted twice this year.

What else does someone considering investing in a 529 plan need to know?

Most of the people who administer 529 plans do a good job of communicating the variety of investment options, but you have to make sure that the college or institution you’re considering is eligible.

Investors should also be diligent in reviewing the enrollment and maintenance fees for these accounts, as well. The Web site reviews the state tax benefits on a state-by-state and plan-by-plan basis. It also does a good job of comparing the enrollment fees and investment fees. A wealth of information is available both online and from your financial adviser. ●