Smart Strategies

Gone are the days when saving for college meant opening a custodial account or collecting low-yielding savings bonds. With college costs climbing about 5% per year, parents have to save more aggressively and take advantage of every tax break. In recent years, Congress and state governments have responded with new rules and options designed to help. But so many choices and changes can be confusing. So to help you pick the best plan, here's a report card for the entire class of college savings options.

Head of the class

State-sponsored college-savings plans -- known as 529 plans -- are at the top of the list for both long- and short-term college savings. Not only are the earnings tax-free, but some states let residents deduct contributions on their state tax returns.

Parents, grandparents, aunts, uncles -- anyone -- can open an account for a child with as little as $25 or $50 and make contributions regardless of income. Contribution limits vary by state, but all states let you contribute more than $200,000.

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The money can be used for qualified higher-education costs -- tuition, room, board, books and transportation -- at any accredited college in the U.S. and some foreign countries. And there's no rush to use the money because students can use the money at any age in most states. For more about the benefits of college-savings plans, see "529 Plan FAQs."

The downside is that the state controls your investment options. More choices that range from conservative to aggressive asset allocations are being added in many states, however. And you can switch investment tracks within a plan once a year or roll your savings into another state's plan without penalty.

Another possible drawback to these plans might be their impact on financial aid eligibility after the freshman year. For now, money in these plans is considered to be a parental asset, which counts little when figuring how much aid a family will initially receive. But the Department of Education hasn't decided whether a 529 plan distribution will count as "student income," which could significantly reduce aid in subsequent years. There likely will be a decision on the issue by 2003.

Consider an age-based portfolio that invests mainly in stocks when the child is young and gradually shifts to bonds and money-market funds as college age nears. Check your state's plan for investment offerings and contact information.

If your state doesn't offer a plan, or you unsatisfied with the investment options, consider plans beyond your borders. College Savings Iowa, Michigan Education Savings Program, Minnesota College Savings Plan and Virginia's College America are all top-notch picks. The first three are all direct sold state savings plans and the Virginia plan is our favorite broker-sold plan. Find out why these are our favorite picks.

Best for those who like to pick their own investments

A Coverdell education savings account, formerly known as an education IRA, give you complete control over your college savings investments. And you get a little more flexibility on how you spend the money. For example, you can make tax-free withdrawals to pay for elementary and high school expenses.

Finding a home for your ESA might take some effort. Many mutual fund companies have chosen not to offer the accounts. Check with Janus or Charles Schwab for funds with no annual fee.

But ESAs contain more contribution restrictions. For example:

• You can contribute only up to $2,000 a year in an ESA.
• You can only contribute if your adjusted gross income is less than $190,000 on a joint return ($95,000 on an individual return).
• Anyone can open an account for your child, but total contributions can't exceed the annual $2,000 limit. You'd have to contribute the maximum for 18 years (assuming a 10% return) to reach $100,000 -- probably enough to pay for four years at a public college.

The funds also must be used (or transferred to someone else) before the beneficiary turns 30. And ESAs will also have a bigger impact on your quest for financial aid since the money is in your child's name. If you think you'll need to apply for aid, your best bet -- for now -- is a 529 plan.

Best if college is a few years away

Traditional prepaid-tuition plans -- available in 18 states -- let you pay future college bills at today's prices. That's an attractive option because tighter state budgets are expected to accelerate tuition inflation over the next few years.

By high school, you want to be pulling back on risk anyway, so the kind of return you can expect in a prepaid plan is competitive with (if not better than) safe havens such as money market mutual funds or short-term bonds. But prepaid plans generally are too conservative and inflexible for longer time horizons.

Best for fall-back funds

Roth IRAs were built for retirement. They're not ideal for college savings, but the tax rules include provisions that can help education savers in a pinch. You can withdraw your principal from a Roth penalty-free at any time. In general, if you withdraw the earnings before age 59 ½ you'd get hit with income taxes and a 10% penalty. If you use the money for college expenses, however, the penalty is waived.

Remember, too, that Roth withdrawals will count as parental income and can impact financial aid.

Good for reducing the family tax bill

Traditional custodial accounts (also known as UTMA or UGMA accounts, after the Uniform Transfers/Gifts to Minors Act) were becoming a thing of the past for college savings until changes to the tax law lowered the capital gains rate. The tax on long-term capital gains (the profit from assets sold after one year) is now 15% for those in the four highest tax brackets. For those in the 15% and 10% brackets it's 5%, and drops to 0% in 2008. Children younger than 14 can earn up to $750 in capital gains or other unearned income tax-free. The next $750 in gains would be taxed at 5% (0% in 2008), but any more than that would be taxed at the parent's tax rate.

That's certainly a benefit, but it doesn't compare with a potential tax bill of $0 available with a 529 plan. But custodial accounts let you pick your own investments -- unlike 529s. Also, you likely will be able to pay lower fees than you would for many of the 529 plans. For example, the Vanguard 500 Index Fund (VFIAX) charges just 0.18%. A fee of 0.65% is considered low for 529s. And the money can be used for more than just college costs.

However, custodial accounts have disadvantages. Once your children reach 18 or 21 -- depending on the state -- they get control of the account and can spend the money how they want. Custodial accounts also can affect financial aid because a student's savings weigh more heavily than parents' when schools are determining aid.

Most 529 plans allow you to transfer custodial account funds into them, but the money can't be shifted to another beneficiary and your child still will control it when he reaches the age of majority. You'll have to sell any investments in the custodial account -- and pay capital-gains taxes --to shift the money. Any additional contributions should be put into a separate account in the 529 plan so the parents can control that money.

Select the strategy closest to the number of years you have to save:

• 18 Years to Go
• Ten Years to Go
• Five Years to Go
• One Years to Go
• Last Minute

Figuring the Cost

With 18 Years to Go