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The Best Way to Save for College

Changes in the tax code last year greatly enhanced two options for moms and dads. The big improvements: a sharp increase  -- from $500 to $2,000 a year  -- in the amount you can save in a tax-advantaged Coverdell Education Savings Account, or ESA (formerly known as the Education IRA), and the exemption from federal taxes of qualified withdrawals from the state-sponsored college-savings plans known as 529s.

Which of these two makes the most sense for your family? It depends. According to experts:

Consider an Education Savings Account if...

  • You might use the money to pay elementary or secondary private- or parochial-school tuition. ESAs permit penalty-free withdrawals to pay for kindergarten-through-12th-grade expenses (529s don't), as well as college and graduate-school bills.

  • You want total control over your investments. ESAs allow you to invest your contributions any way you wish and change those investments as often as you like.

    Consider a 529 plan if...

  • You'd like professional help choosing your investments. Most 529s offer several professionally managed mutual-fund portfolios, based on either your child's age or your risk tolerance.

  • You think you'll qualify for financial aid when your child is ready to go to college. Savings in a 529 aren't counted as heavily in financial-aid formulas as are assets in an ESA.

  • You can afford to invest only a small amount. Some 529s require an initial investment of as little as $25.

  • You want to invest more than the $2,000 a year ESAs allow. 529s don't restrict annual contributions (though total giving is often capped).

  • You live in one of the 24 states that currently offer a state tax deduction for contributions to 529s (to find out if you do, visit savingforcollege.com).

  • You may need the money someday. Unlike an ESA, which must be used for your child's education, 529s can be reclaimed by the account owner (who'll owe taxes and a penalty).

    Contributing editor Diane Harris is coauthor of the women's personal-finance book It Takes Money, Honey.

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