Diversify Your College Savings

My wife and I are in the process of getting our 15-month-old child enrolled into a college-savings plan. When he was born, I opened a Franklin Templeton Founding Funds Allocation Fund, Class A for him, where I put any baptism, birthday, Christmas and other gift money he receives. Since the success of that fund relies on the market, I was leaning toward enrolling him in the Florida prepaid college fund account, which is guaranteed by the state. I felt that when it comes to his future and college, a "sure" thing might be the smarter way to go and leave any growth or money-making we can do in the Franklin fund. Are we doing the right thing here?

You're on the right track. Having some money invested in a good prepaid tuition plan and some in mutual funds can be a good way to diversify your college savings.

Prepaid tuition plans generally promise to pay for tomorrow's tuition at today's prices -- no matter what happens to the stock market. It's a good way to get a tax-free benefit whose value rises with the cost of college, which increased by an average of 6.6% for four-year public colleges over the past year.

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The specific value of the prepaid tuition plan depends on your state, and you're lucky to live in Florida. "This is one of the few states that still has a prepaid tuition plan that has not been changed or scaled back," says Mari Adam, a certified financial planner in Boca Raton, Fla., who invested in the state's prepaid plan for her own children.

Many other states had to reduce their prepaid tuition plans's benefits because of state budget troubles. They are either charging new investors a premium of 5% to 20% on top of current tuition or temporarily closing their prepaid plans. For more information about the changes, see Future Tuition at Today's Prices.

You can sign up for Florida's prepaid tuition plan only if the child, parent or guardian has been a resident of Florida for at least 12 months. But the child doesn't need to attend college in Florida to reap the benefits.

The plan promises to cover the cost of Florida state colleges, but you can use the money at almost any accredited private or public college throughout the U.S. (see the Florida Prepaid College Plan Web site for more information about the rules and the full list of eligible colleges). The only limitation is that the prepaid amount only covers the cost of a public college in Florida, and Florida does have some of the lowest tuition costs in the country.

Because the plan might not cover your full bill for tuition, plus room and board and fees -- especially at an out-of-state or private college -- it's a good idea to supplement your prepaid tuition plan with other investments. But the fund you've chosen has a 5.75% front-end load and an expense ratio of 1.20%. You can find similar funds that are a lot less expensive, such as Vanguard Wellington or American Funds Capital Income Builder, says Adam.

A much better option would be to invest that part of your college savings in a 529 college-savings plan. "A custodial account is probably the least attractive way to save right now -- both for financial aid and tax reasons," Adam says. Because of new kiddie-tax laws, investment income over a certain limit is taxed at the parents' higher rate (generally 15% for long-term capital gains) rather than the child's rate for dependent full-time students younger than age 24.

Money in a 529, on the other hand, can be withdrawn tax-free for college costs. And about half the states offer a state income-tax deduction for 529 contributions.

Because Florida doesn't offer a state tax break for 529 contributions, Adam generally recommends the Utah plan for her clients, which has low fees and a variety of Vanguard funds. See The Best Way to Save for College for more information about 529s and The Best 529 College-Savings Plans for a list of our favorites.

You can sign up for a 529 at any time. Many prepaid plans -- like Florida's -- are only open for new enrollment in the fall, which is also when the new costs will be announced. The price varies depending on your child's age.

When checking out the prepaid tuition plan in your state, find out what will happen to the money if your child doesn't go to a state college and whether your state has added a surcharge to current tuition costs. In that case, calculate how long it would take to earn back the surcharge if tuition increases at, say 5% per year. The older the child, the less likely he or she will be able to make up for the surcharge.