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Pitfalls to avoid when setting up a college fund.
2 min read

This story appears in the December 2006 issue of Entrepreneur. Subscribe »

Parents participating in state-sponsored college savings programs can breathe more easily now that the Pension Protection Act has made the federal tax exemption on Section 529 tuition plans permanent. Prior to enactment of the Pension Act, the exemption would have been phased out in 2010, making even investment earnings earmarked for education subject to taxes, explains Rick Darvis, co-founder of the National Institute of Certified College Planners.

But despite the change, 529s may not be the best way to fund your child's education. For example, families eligible for the lifetime learning credit--a $2,000 tax credit available to families that spend more than $10,000 in tuition and fees--cannot claim a tax-free withdrawal of 529 funds for that $10,000 tuition expenditure. "That's called double dipping," explains Darvis. "And if you do it, three years later you will get a certified letter from the IRS saying that you owe back taxes, penalty and interest."

Even for parents who earn too much to qualify for that tax credit ($55,000 for singles and $110,000 for couples), 529s can be a less than efficient education savings option. "Often, a lower rate of return will more than offset the tax benefits," says Darvis, who urges parents to take a hard look at plan fees and return rates before taking the 529 plunge. "You can invest for college using a tax-efficient mutual fund and get a better rate of return after you adjust for fees," he explains. "And that money can be used for any purpose; it's not limited to education expenses."

Jennifer Pellet is a freelance writer specializing in business and finance.