With the costs of higher education continually rising, it’s more important than ever to get an early start saving for a college education. For parents or grandparents considering education-funding possibilities, Section 529 state-sponsored College Savings Plans may be the way to go.

The ABCs

College Savings Plans allow you to invest significant sums of money that can grow tax-free. You can set up an account for anyone — your child, grandchild, niece or nephew, even yourself. These accounts grow larger than an identical taxable account where earnings are taxed every year.

The reason? Dividends and realized capital gains are not taxed annually and continue to grow within the account. Additionally, when the money withdrawn is used to pay for qualified education expenses such as tuition, fees and certain room and board expenses, supplies and equipment, it’s free from federal income tax.

Many states, including Arizona, also extend favorable tax deductions and tax-free withdrawals to residents. Check with your tax advisor on this point.

Contributions to College Savings Plans are usually invested in one or more predetermined structured portfolios. Typically, plans include age-based or years-to-enrollment portfolios that become more conservative as the child nears college enrollment. Early on, the portfolio might hold more stocks then shift to more fixed-income investments.

Other options include static portfolios that do not alter their investment allocations over time or individual fund portfolios that allow for more customization. Of course, the performance of the portfolios depends on market conditions and there is no guarantee there will be enough money in the account to cover all education expenses.

Do the math

To fully understand the benefits of 529 plans, it’s a good idea to compare how they stack up against more traditional plans. If you’ve started to explore education-funding possibilities, you have probably found that most traditional savings plans come with limitations.

For example, with an Education Savings Account (ESA, formerly an Education IRA) there’s a $2,000 a year limit on savings — not much given that tuition, room and board can cost tens of thousands of dollars for a four-year education. And while these accounts do provide tax-free distributions, parents with relatively high incomes may not be allowed to contribute.

Custodial accounts present other dilemmas. The child owns the assets since the account is in his or her name, but the latest changes in the taxation of unearned income by minors has been extended all the way through age 18, and up to age 24 for college students. That means you can hope your college-bound teen decides to use the money for college, but no matter how the money is spent, much of the investment income will be taxed to you at your highest marginal tax bracket.

U.S. Savings Bonds are also a popular savings vehicle. But they carry modest interest rates.

Do your homework

There are a couple of things you’ll want to consider when evaluating 529 plans.

First, read up on Arizona’s College Savings Plan – the website is http://az529.gov/az529/index.htm – or the plan for whatever state you’re thinking of investing in.

It’s also import to weigh the local tax benefits. (For example, starting this year, Arizonans who contribute to a 529 college savings plan can receive an income tax deduction up to $750 annually for an individual or $1,500 for married joint filers.)

If you are already saving within a custodial account, an ESA, or with U.S. Savings Bonds, you may want to explore the tax-free transfer of these savings to a College Savings Plan.

Finally, keep in mind that if the funds aren’t used for educational purposes, you’ll face a 10 percent penalty tax on earnings upon withdrawal. Still, many families find the benefits of the plans greatly outweigh any potential disadvantages — last year alone they invested around $5.5 billion.

Your Financial Advisor can provide more information, as well as help determine, which plan may be best for you based on you unique situation. Whatever path you take, remember — these plans offer a great way to prepare for your child or loved one’s college education.