A red flag raised on college-savings plan

State college-savings plans, known as 529 plans, may benefit families who fall in upper-income brackets much more than middle- and lower-income families, according to a report in the February issue of the Journal of Financial Planning.

The tax-deferred plans have been described as an ideal way to save for a child's tuition. But the article says the tax savings from 529s might not be as high as the amount of financial aid a middle- or lower-income family loses as a result of having the plan. That's because when a need-based student withdraws money saved in a 529, the money is treated as "increased income," driving down the amount of financial aid available.

Consider two families in the 15-percent income-tax bracket. One puts $2,400 a year in a 529 plan for an 8-year old child; the other saves that amount in a taxable mutual fund. Assuming a 10 percent rate of return over 10 years, the family using a 529 would lose $8,912 in net financial aid from the college, while the one using the mutual fund loses only $2,136. In the 28-percent tax bracket, the family using a 529 loses $6,782 in potential aid, versus $2,008 for the family saving in a taxable mutual fund. Parents in higher income-tax brackets benefit from 529s because they are often ineligible for financial aid. For more information about 529s, now available in 33 states, see www.collegesavings.org.

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