Section 529 plans (named after the IRS Code Section) allow individuals to set up an account on behalf of another individual (typically a child or grandchild) that can be used to pay college expenses. A recent law change has also allowed up to $10,000 to be used for tuition expenses for elementary and secondary public, private and religious schools.
The funds used as contributions are after tax, but any earnings within the account are tax-free as long as they are used for qualified educational expense. Even better, anyone can contribute to an account.
There are two types of plans:
Prepaid tuition programs are designed to hedge against inflation. You can purchase tuition credits, at today's rates, that your child can redeem when he or she attends college. Both state and private institutions can offer prepaid tuition programs. Using tuition credits from prepaid tuition programs is tax-free.
College savings accounts let you build a fund for your child's college expenses. Once in the plan, your money grows tax-free. Provided the funds are used to pay for qualified college expenses, withdrawals are tax-free. Qualified expenses include tuition, fees, books, supplies, and certain room and board costs. Private institutions are not allowed to set up college savings accounts, so each state sets up their own 529 plan in conjunction with a third part administrator.