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Consider quick-draw strategy for in-state Section 529 deposits

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The Tax Increase Prevention and Reconciliation Act offers parents great impetus to fund a child’s higher education through a Section 529 college savings plan.

Why? Because Section 529 earnings are exempt from the “kiddie tax,” which, under the new law, now extends to children who are age 17 or younger at year-end.

But if your child will enter school within the next year or two, you don’t have much time to build up tax-deferred savings.

Strategy: Use a Section 529 as a tax-free “parking spot,” by contributing to a state-sponsored plan, then quickly withdrawing the money as you need it to pay your child’s college expenses. In most states, this quick in-and-out approach may provide a little-known state income tax break for those whose children attend schools in-state.

Here’s the whole story: Section 529 plans generally are operated by individual states. If they meet certain requirements, Section 529 participants pay no federal income tax on the accumulation of earnings and no federal income tax on distributions when the funds are finally paid out to cover qualified higher-education expenses.

Note: The rule for tax-free distributions is scheduled to expire after 2010, but it’s likely that Congress will extend it.

Two types of Section 529 plans exist: The prepaid-tuition plan and the college savings plan. With a prepaid-tuition plan, you can lock in rates at an in-state public college or university. A college savings plan provides greater flexibility, but offers no guaranteed tuition.

Every state offers at least one type of Section 529 plan. You can join a plan in a state you don’t reside in, but you may do better tax-wise by staying at home. Reason: More than half the states offer a deduction or credit for Section 529 plan deposits by residents. So, if you put money in your state’s plan, you might realize a state income tax break, even if you pull the cash out right away.

This strategy works for the college savings plan, but it generally isn’t allowed for prepaid-tuition plans. A few states, including Michigan, restrict the right to withdraw funds during the first year. While some state officials frown on that practice, they don’t prohibit it.

How much can you save? It depends on the state and the size of your contribution. Refer to the chart below.

Tip: Use conservative investment methods if you’ll be withdrawing funds soon. Don’t run high risks for short-term investments.

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