With tuition rates rising faster than inflation, saving for college is a daunting task.

With many investment vehicles to choose from, you might want to consider a 529 plan.

A 529 plan is an education savings plan operated by either a state or higher education institution designed to help families save for college.

There are a variety of factors to take into consideration when deciding if a 529 is an appropriate  investment vehicle for your family, including: your state’s particular regulations on 529 plans, your financial situation and the age of your child.

There are two types of 529 plans: savings and pre-paid plans.

A savings plan serves as a 401(k), and allows the investor to choose from a set of investment options such as mutual funds, CDs or stable value options depending on the plan.

A pre-paid plan allows you to lock in the current tuition rate and pay out the future rate when the beneficiary heads to school. These plans are generally used at in-state schools and public colleges, but can also be converted to include private and out-of-state schools.

To find out specific information about plans, go here.

You can enroll in a 529 plan either through a plan manager or a financial advisor.

When investing in 529 plans for a particular state, you may not have as much freedom with your investment choices.

“You can’t buy individual securities; you can’t buy individual stocks and bonds, or real estate,” says Margaret Munro, author of 529 and Other College Savings Plans for Dummies. 

“You are very limited in your choices. Because most of the plans are state run, each state can dictate what your choices are.” 

Conditions of the Plan

Any money taken out of a 529 plan that is not related to education will be slapped with a penalty.

 “Withdrawals for qualified higher education expenses are free of both federal and state taxes,” says Chris Hunter from the College Savings Plans Network. “The earnings portion of a non-qualified withdrawal is taxed as ordinary income plus a 10% penalty.” 

To make sure your dependent’s expenses are appropriate, Hunter suggests keeping all receipts, invoices and any other paperwork associated with your costs.

 “The account owner and/or the beneficiary generally have the responsibility to ‘self-substantiate’ qualified-higher education expenses under federal and state tax law,” he says.

However, there are some exceptions for withdrawals that do not incur penalties.

“If the beneficiary dies or becomes disabled, no penalty withdrawals can be made as a result,” explains Joe Hurley, founder of Savingforcollege.com.

“If the beneficiary receives a tax-free scholarship or is attending a U.S. military academy where essentially they don’t pay tuition, then those withdrawals also escape penalty.”

In order to maximize your contributions, Munro suggests that a relative, like a grandparent set up a 529 plan instead.

“When it comes time to apply for financial aid, it doesn’t count as EFC,” she says. “If they were going to help anyway, it’s a good idea.”

Benefits of a 529

Restrictions on how money in a 529 can be spent can deter students from using it on non-education related items.

Depending on your investment strategy, you can also get some peace of mind with insured investments.

 “There are certain types of investments in some 529 plans that have more principal protection.,” says Hurley.

“For example, there are some bank products in some 529 plans that have FDIC insurance. There are some so-called ‘guaranteed options’ that are backed by life insurance companies, so they will protect your principal through their agreement with the life insurance company.”

If your child decides college isn’t in the cards, all is not lost. You can simply roll the funds in the 529 over into an account for someone else.

“You don’t have to roll over the full amount,” says Munro. “You can rollover a portion into a plan for another qualified beneficiary, no penalty.”

Should you decide not to roll the money over, you may take out the funds—but you will pay taxes on the earnings plus the 10% penalty.

Potential Pitfalls 

A 529 plan may limit the financial aid your child will receive, since it may count toward your Expected Family Contribution (EFC), or the amount that your family is expected to put toward your child’s education, which reduces the amount of loans or grants received.

“When it comes to financial aid, any assets that a parent or child owns [not just 529 plan assets] can affect your eligibility for need-based financial aid,” says Hunter.

 “With 529 plans, your account is considered to be an asset of the account owner. Assuming the account owner is the parent, this means that, on average, about 5.6% of the value of the account is considered in determining the Expected Family Contributions. With many other savings vehicles, such as a custodial accounts or assets that are in the name of the student, 20 percent of the value of the assets is considered in determining the EFC.”

Another factor in a 529 plan is the fee charged by the plan or broker.

“There is the potential to pay an awful lot more in fees for this type of plan than you would for a regular investment account,” she says.

If you prefer to have more freedom in your investment choices and decisions, a 529 plan may not be for you. 

“One of the downsides of the 529 plan is of course that the investment choices are so restricted and it’s so costly,” says Munro. “If you don’t have enough to pay for your kid to go to college, is it wiser to put this money in other sorts of investments so that you could use it for college or something else?”