College savings 529 plans, which allow individuals to save money for higher education in tax-free investment accounts, have proved so popular that there are now about 10 million of the accounts nationwide, according to Financial Research Corp. Funds saved in the state-sponsored accounts can also be spent tax-free, but you have to follow the rules.
• Anyone — parents, grandparents, friends — can set up 529 plans for prospective college students. You can even establish one for yourself. There are no income or age limitations. Whoever sets up the account — the "custodian" — remains in control of the money until it is spent.
• You can invest in any state's 529 plan, although some states offer extra tax advantages to their residents. All 50 states and the District of Columbia have plans, and they differ in some ways, including in the fees charged. To check out the different plans, go to Savingforcollege.com.
• The IRS allows 529 money to be spent tax-free on tuition, fees, books, supplies, required equipment and the education expenses of special-needs students. Room-and-board expenses are also allowed, but only up to the amount the school specifies to the federal government.
• You cannot spend 529 money on activity fees, insurance and other costs not required for enrollment, according to Savingforcollege.com. You also cannot spend it on transportation costs, repayment of student loans or on a computer, unless the college requires students to have their own computers.
• Be careful how much money you take out of a 529 plan. If you withdraw more than is needed to pay qualified higher-education expenses, you'll have to pay income tax on that amount. And that's not all: There's a 10% federal penalty tax on the earnings portion of an ineligible withdrawal.