How do the tax benefits work?

Simply put, all earnings on a 529 plan account are deferred from federal taxes. You won't pay federal taxes on earnings, and you won't be federally taxed if you use the money for qualified educational expenses such as tuition, room and board, and books. (There may be penalties if the money is used for non qualified college expenses.) Please note that the availability of tax or other benefits may be conditioned on meeting certain requirements such as residency, purpose for or timing of distributions, or other factors as applicable.

The tax advantage can be a significant one.
Since earnings aren't taxed, they can grow as much as 30% faster than they would in a taxable account.

Here's an example.
This chart shows how much faster your contributions could grow in a 529 plan versus a taxable account, over a period of 18 years.

Tax-free Growth Over 18 Years

This example assumes that the account started with $15,000, with monthly contributions of $250, and hypothetical annual earnings of 8%. The tax savings are based on the 31% tax bracket. (The example is for illustrative purposes only and is not intended to represent the return on any specific investment.)

What about gift taxes?
Contributions are considered completed gifts for federal tax purposes, so they qualify for federal gift tax exclusions. In fact, you can contribute up to $65,000 ($60,000 in 2008) in a year ($130,000 for married couples), and incur no federal taxes if you average the gift over 5 years.

Those rules apply to grandparents and other relatives as well, and can be especially advantageous if they wish to contribute a large amount at one time. However, grandparents in particular should keep in mind the generation-skipping transfer tax when considering gift tax consequences.

Important note.
The rules regarding gift taxes, estate taxes and the generation-skipping transfer tax can be very complex and are subject to change. We recommend that you ask a tax advisor and/or the IRS about your particular situation.

If you are not an Alaska resident, you should compare this Plan with any 529 college savings plan offered by your home state or your beneficiary's home state and consider, before investing, any state tax or other benefits that are only available for investments in the home state's plan. You can call 1-866-277-1005 or visit the forms section of our site to request a Plan Disclosure Document, which includes investment objectives, risks, fees, charges and expenses, and other information that you should read and consider carefully before investing. T. Rowe Price Investment Services, Inc., Distributor/Underwriter.