Many states have pre-paid tuition programs allowing families to save for a student's higher education. These plans qualify for special tax treatment if the funds are used for qualified expenses at a post-secondary school that meets US Department of Education standards for student aid eligibility. These plans are generally referred to as 529 plans for the tax code section that describes how they are treated for tax purposes. States offering such plans may also give favorable tax treatment for contributions, interest, dividends, and distributions from these plans. State tuition plans fall into two categories: pre-paid tuition plans and accumulation plans.

Pre-paid tuition plans allow participants to buy tomorrow's education at today's prices. They may be purchased with a single lump sum or a series of payments. The state guarantees that the pre-payments will cover the future cost of education at the state college. If the student chooses not to attend the state college, the state will make available the amount of money equivalent to the cost of the state education at maturity. For example, imagine that a state university costs $8,000 per year today and you pre-pay two years ($16,000), to be redeemed in 8 years. In 8 years, the cost of two years at the state college goes to $24,000. The beneficiary has two years paid for. Should the student wish to attend a non-state school costing $30,000 for two years, the state has to rebate only $24,000 (the cost of the equivalent state college tuition). Pre-paid tuition plans are not as popular today as they were a few years ago due to the phenomenal run-up in the investment markets that occurred in past years.

State college accumulation plans have become more popular because of investment flexibility and the alluring possibility that, with investment skill and luck, proceeds may exceed the actual costs of education. These plans have some tax incentives, too. While the contributions generally are not tax-deductible, the accumulation within the plans is tax-deferred until withdrawn. Even then, the accumulations may be tax-free if used for qualified educational expenses. Contributions to a plan may not exceed more than the amount necessary to provide for the qualified higher education expenses of the beneficiary (student). The contribution limits are often set by the plan administrator each year.

There are no income taxes due on the value of these plans until the proceeds are distributed. Then income tax is due only on the increased value of the plan over the contributed amount. The taxes are calculated at the beneficiary's rate, i.e., based on the student's income. Some states even waive income tax on funds used for qualified educational expenses. If funds are disbursed and not used for qualified education expenses, a 10 percent IRS penalty may be due unless the disbursement meets special requirements. The penalty may be waived if the refund of earnings is made because:

Qualified higher educational expenses include tuition, fees, books, reasonable room and board, supplies, and equipment required for the beneficiary at an eligible educational institution. The student must be enrolled at least half time.

Amounts can be transferred to other qualified state tuition programs, and beneficiaries can be changed. Amounts in a qualified state tuition program can be transferred tax-free to the qualified state tuition program of another beneficiary. The transfer must be completed within 60 days of the distribution, and the other beneficiary must be a family member of the beneficiary from whose program the transfer is made. The new beneficiary must be the existing beneficiary's spouse or one of the family members listed below:

Qualified state tuition plans are more popular than the Coverdell account because of the higher contribution limits and the ability to use qualified expenses as the basis for the Hope tax credit or lifetime learning credit. No contributions can be made to a Coverdell on behalf of a beneficiary if any amount is contributed during the same year to a qualified state tuition program on behalf of the same beneficiary. Any amount contributed to the Coverdell will be treated as an excess contribution.