Qualified Tuition Programs (QTPs) offer another way to provide for college funding. These programs, also referred to as Section 529 Plans, generally have a tax-favored status. Individuals may participate in either a prepaid tuition plan or utilize a higher education savings account plan.

Prepaid Tuition Plans

These programs are administered by a state or by an eligible educational institution. Under these plans, participants purchase tuition credits or certificates for a designated beneficiary, who would then be entitled to a waiver or partial payment of qualified higher educational expenses. Contract purchasers prepay tuition and fees for a set number of academic years while locking in current tuition rates. In-kind distributions from these plans, such as a waiver of tuition, generally are excludable from gross income for plans maintained by a state. For plans that are maintained by a private institution, in-kind distributions generally will be excludable from gross income. To be excludable, the distributions must be used for qualified higher education expenses.

Higher Education Savings Account Plans

These programs are generally sponsored by a state. Under these plans, participants make contributions to an account that is set up to meet qualified higher educational expenses of a designated beneficiary of the account. There are no income limitations with regard to making contributions to the plan.

Contributions are made to a state's savings account and are generally managed by private investment or insurance companies. Each state imposes a limit on the amount of contributions that can be made to the plan per beneficiary, and on how large the account balance can grow. Some states allow a state income tax deduction for contributions made. These plans generally allow for the interest earned to be withdrawn tax-free. The withdrawals must be used for qualified higher education expenses. If withdrawals are made for purposes other than qualified education expenses, the amount of earnings that are withdrawn are taxed at the beneficiary's income tax rate and also subject to a 10% penalty.

IMPORTANT NOTE: You can contribute to any state's savings plan. Most plans have no state residency requirements. Therefore, you need not contribute to the plan of the state in which you live or where your child may attend school. By investing in a 529 plan outside of the state in which you pay taxes, you may lose any tax benefits offered by the state's plan. Consider before investing whether you or the designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such states' qualified investment plan.

There are rules that the federal government has established, and which must be adhered to under both types of plans. For example, the account cannot be used as security for a loan. There are other rules to be followed and a state or eligible educational institution may also give direction regarding how its particular program works. The American Opportunity Tax Credit and the Lifetime Learning tax credits can be claimed in the same year as QTP distributions, as long as the QTP distribution is not used to pay for the same costs used to claim the education credit.

Individuals can contribute to both QTPs and Education Savings Accounts on behalf of the same beneficiary. Amounts in a QTP can be rolled over to another state's plan once per year.

SUGGESTION: Assets in a QTP are treated as the parent's assets when applying for financial aid if the parent is the donor. Contributions to QTPs qualify for the annual gift tax exclusion. The person contributing the money to the program may elect to treat the contribution as if made over a five-year period for purposes of the annual gift tax exclusion.