Best Short-term Investments for College

For families who have years to go before the college bills arrive, it's easy to decide where to build a tuition kitty: Use a state-sponsored 529 plan and reap a tax bonanza. Your savings grow tax-deferred and escape taxes altogether if you use the money for qualified college expenses. Plus, more than half the states give you a state-tax deduction or other benefit for your contributions.

But suppose your child is headed off to college next fall and fortune smiles on you, in the form of a bonus, an inheritance or some other windfall to help pay the tuition. Is a 529 plan still the way to go, or should you stick with the safety of bank certificates of deposit?

That depends on the state you live in, the investment choices within your 529 plan and the amount you'll need next fall, says Chuck Toth, of the College Savings Foundation, a nonprofit that provides policy support for 529 plans. "There's no black-or-white answer."

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If you're eligible for a state-tax deduction and your state's plan offers a no-fee, guaranteed-investment option that protects your principal, putting a year's worth of tuition and room and board into the 529 account makes sense, says Gary Carpenter, a certified college financial planner in Syracuse, N.Y. You qualify for all three tax breaks, as long as you use the money to cover college costs. (If you withdraw it for other purposes, you'll owe tax plus a 10% penalty on the income.)

Keep the rest of your windfall in CDs, laddered to mature as your child progresses through college, advises Carpenter. Redeem a few CDs each academic year and transfer at least enough of the cash to the 529's guaranteed-investment option to take another tax deduction. (Be sure the plan doesn't impose a waiting period on withdrawals.) If your child doesnÕt return to school, you can cash in the CDs without penalty when they mature.

If your state doesn't offer a tax deduction for 529 contributions, the question is whether your after-tax yield on CDs beats the tax-free yield on an investment inside a 529. Because your timeline is so short, it may be easier to go with CDs, says Toth. "We look at 529s as a long-term investment tool."